A Well-Designed Factor Based Trading Strategy Can Beat The Market By A Factor of 3X

​Can ordinary, non-professional investors beat the market?

The short answer is yes. The longer answer is that it's difficult to beat the market consistently, over time.

There are many ways to beat the market (capture Alpha) but they all involve serious effort up front, and meticulous diligence once you go live with a strategy.

The market has become much more efficient at pricing stocks close to their fair value. But the market is far from perfectly efficient. Alpha is out there, and you can find it - if you know where to look. Here are a few sources of Alpha that still exist in today's machine-dominated market.

​Where does Alpha come from?

  • Day traders. 90% of them lose most of their money within the first year, and then quit.
  • Overconfident stock pickers. They overestimate their skills, and don't learn from their mistakes.
  • Low information traders who buy on rumors and hot tips from unqualified sources.
  • Disorganized types who have no plan, no strategy, and no self-control.
  • Impatient types who jump around from one trading system to the next, never giving them a chance to work.
  • Wealthy investors who pay top dollar for information and tips that have little to no value.
  • Large fund managers who are forced to sell winning stocks in order to meet client redemptions.
  • Index funds and ETFs that must cling to their benchmark, even if that means buying the worst stocks in the index.
  • People who allow their political ideology to drive their investment decisions.
  • People who are enamored with conspiracy theories, or susceptible to investment scams.

These and many other sources of Alpha are a permanent feature of our capital markets. While it's true that skilled and astute investors are ready to step in and capture much of this Alpha, it's also true that very few of them can do it consistently over time. Today's Alpha taker will often become tomorrow's Alpha provider.

​Now that you know where Alpha comes from, how do you capture it?

Most people who set out to beat the market will fail. There are lots of reasons why, but here's a big one. They look at investing and trading as just another challenge to overcome. Perhaps they have mastered other big challenges in life, like academics, politics, or business. 

Or maybe they are really smart, with a high I.Q. and straight A's in school. ​

Here's the problem. None of those skills, talents, and life experiences are enough to​ make you a master investor. They help, but it takes a different set of skills to truly master the game. It takes emotional intelligence, self-awareness, humility, critical thinking, and lots of good old fashioned work.

Some people think investing is an art, and others think it's a science. I think it's both. The art involves thinking creatively and noticing things that others don't. ​It involves intuition and instinct, but these are often riddled with mental and emotional bias, false beliefs and assumptions, and wishful thinking. 

How can we design a strategy that minimizes these things and gets us closer to the relevant facts?

​One type of strategy I've been using with clients for years is factor-based screening.​ Factors have become quite popular lately, but I believe this approach will continue to produce results for many years to come.

All ZenInvestor trading strategies have been carefully designed, tested, and executed in real time. We don't make these strategies available to subscribers until we have at least one full year of actual performance to evaluate how they work in the real world. 70% of our strategies never make it out of the lab.​

The Science of Capturing Alpha

(Beating the Market)

Capturing Alpha is Difficult... but Not Impossible

Why is it that a minority of people succeed in the market while most fail? After all, it’s the same market with the same stocks for everyone, right? So why the big difference in performance between one person and the next?

It comes down to these two things:

1) Having a clearly defined strategy, and
2) Having the courage & discipline to follow through, no matter what.

​What about you? Do you have a clearly defined strategy? And do you have the courage and discipline to follow through?

If you focus on your own strategy and block out the noise of daily market action, you will increase your odds of success dramatically. I'm not exaggerating when I tell you that you could double your returns with a factor based strategy. How do I know? Because I've been doing this with my clients since 2005, and I have the numbers to back it up. 

Factor-Based Screening Is a Powerful Tool for Investors

• Did you know that the most popular, loved, and respected companies are usually not good stocks to buy? By the time you hear about how great the company is, the easy money has already been made?.

• Did you know that stocks that are making new highs are twice as likely to continue going higher than stocks that are 10% or more below their all-time highs?

• Did you know that companies who raise their earnings estimates outperform those who don’t, by a factor of 2-to-1?

• Did you know that companies that are being upgraded by analysts outperform those being downgraded, by a factor of 5-to-1?

There is a better way to find winning stocks

How do you find stocks that have the characteristics that make them attractive candidates for buying? You could do what most investors do, and spend hundreds of hours painstakingly evaluating scores of companies, looking for those rare diamonds in the rough. Or…

Or you could accomplish the same goal in a fraction of the time by using one of the most powerful tools an investor can have:

A Factor-Based Screening Algorithm

Don’t let the name of this powerful tool intimidate you. The tool itself has been built by rocket scientists, but you don’t have to be one to use it. In fact, it’s so easy to use, you will end up saving tons of time, effort, and frustration in your quest for winning stock candidates. You will wonder why you didn’t find out about this tool sooner.

Why Should You Use a Factor-Based Screening Algorithm?

Because there are more than 8,000 stocks out there, and you need a way to find the ones that are poised to move higher. So, you have a few choices.

You could just buy the stocks that are touted by talking heads on TV, written about in the financial press, or offered for free on the internet.

You could get your tips from friends, business acquaintances, or family members.

You could call a psychic hotline, or pay a visit to Madam Ruth. (You know, that gypsy with the gold-capped tooth?)

But how much information do these people really have? How much research did they do? Are they just repeating rumors, making assumptions, or engaging in pure guesswork?

How do they know which stocks meet your standards?

You already know the answer: They don’t.

If you want to find stocks that meet your criteria, you can find them quickly and easily with a factor-based stock screener. But, just because you narrow down the list of 8,000 available stocks to just a few dozen, that doesn’t mean that you’ve identified the best stocks to buy right now. In fact, your list of candidates could be top-notch, but your timing could be awful. How will you know?

The Answer is Backtesting

Once you’ve set up your screening algorithm, you can backtest it to see how well it has performed in the past.

Does it find stocks that go up once they’ve been purchased, or not?

Does it have more winning periods than losing ones?

Does it work in both bull markets and bear markets?

Are the weekly or monthly performance results too volatile for you to handle?

This is important stuff to know when you invest with a factor-based screening strategy. With backtesting, you can see how successful your stock picking strategy has performed in the past, so you’ll have a better idea about what your probability of success will be now and in the future.

However, never forget the fact that past performance is no guarantee of future results. What has worked in the past may not work in the future. But here’s the important question: What else do you have to go by?

There is no such thing as forward-testing, because the future hasn’t happened yet. Present-testing would only give you a snapshot of how the company is doing today. But it gives you no indication of what may happen tomorrow.

Wall Street analysts get paid handsomely to forecast (guess) what is likely to happen in the future, but their estimates about future earnings, revenue, and stock price have been proven to be unreliable at best, and completely off the mark in many cases.

Where do we go from here?

Keep in mind, a screening and backtesting program is not a sack of magic beans. Anybody who tries to sell you a trading system that they claim is guaranteed to beat the market is a charlatan. It’s a claim that can’t be made, except by hucksters and pirates.

The advantage of using a factor-based trading strategy with backtesting capability is that it’s a great way to see what worked and what didn’t BEFORE you put your money at risk.

You can paper-trade the strategy at first, to get comfortable with the procedures and see how it performs in real time. After you tweak the parameters a little to suit your tastes, you are ready to go live.

“I don’t have the time or knowledge to build a strategy like this.”

That’s the point! You don’t have to build a strategy like this on your own, from scratch. You could, and many of my clients have done so, but it’s not the only way to go. You can outsource the research, design, backtesting, and maintenance to someone who does this for a living.

4 Screening Strategies That Make Money

(in up markets and in down markets)

You can easily master this tool without taking an expensive trading course or attending a 3-day seminar. If you follow a set of simple, easy-to-learn trading rules, you'll have a much higher probability of succeeding.

Trading the Strategies

Each of the trading strategies has a clearly defined set of trading rules. 

All stocks are purchased with an equal dollar amount. At the end of the holding period (4 weeks), the screen is run again, keeping the stocks that remain qualified, selling the stocks that no longer qualify, and replacing them with new stocks that do qualify.

The Holding/Rebalancing Period is the amount of time a stock will be held once it qualifies for inclusion in the portfolio. In most cases, the holding period is four weeks (unless otherwise indicated).

Calculating Performance

At the beginning of each holding period, a list of stocks (portfolio) is generated. The period’s returns are calculated using the % change in price from the beginning of the holding period to the end of the holding period, plus any applicable dividends.

Win Ratio: the number of winning (profitable) holding periods out of the total number of available holding periods within the backtested time span. For example; if there were 39 winning holding periods out of a total of 52 available holding periods, the win ratio would be 75%.

The returns for the portfolio is the arithmetic mean of the returns for the individual companies in the portfolio. Compounded performances (when stated), were calculated by taking a hypothetical starting equity amount and calculating the total return for the period. Each subsequent period then used the resulting equity balance as its start to calculate that period’s total return.

No allowance was made for commissions, fees, trading friction, or any other cost constraints, in any of the performance calculations.

Strategy #1 Zen High Quality Plus

Parameters: High quality, rising earnings and earnings estimates, and recent analyst upgrades.

For this strategy we define high quality in three ways. Quality of earnings (earnings that are increasing steadily, that come from improving productivity, and are not vulnerable to price wars.)

The second measure of quality is price performance compared to other companies in the same business. A high quality company will outperform it's competition consistently, and by a comfortable margin.

The third measure of quality is expanding market share, improving ROE (return on equity), and increasing profit margins.

After we screen for quality factors, we apply two additional filters: A positive change in earnings estimates for the current quarter and fiscal year, plus ratings upgrades from the analyst community.

Positive Change in Earnings Estimates (over the last 4 weeks)

This screen looks for positive current quarter and fiscal year estimate revisions over the last 4 weeks. If a company’s current quarter is seeing downward revisions, this is a potential warning sign that more downward revisions could follow. On the other hand, a company receiving upward earnings estimate revisions should see even more upward earnings estimate revisions, making it an attractive candidate for purchase.

Positive Analyst Rating Change (over the last 4 weeks)

This screen looks for stocks with positive analyst rating changes (upgrades) over the last four weeks. This is a good indication that the analysts covering the stock are becoming more bullish. And with studies showing that stocks with recent analyst upgrades outperform those with no rating change, and even more so vs. stocks with ratings downgrades, this additional filter increases the odds of success.

These two filters, when added to the high quality screen, produce powerful results. 

The Results

Over the last 17 years, the Zen High Quality Plus strategy, using a four-week holding period, delivered an average annual return of 26.4%. And it was up 58.1% in 2016.

For those who want to be a little more aggressive, this strategy can also be traded every week, instead of every 4 weeks. Rebalancing every week is ideal for those who are willing to spend more time and prefer more trading action. And it produces better results than the 4-week holding period.

How To Get It

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