One recurring theme in our investment methodology is that
stock prices are a reflection of fundamental intrinsic value and perceived investor emotion /
sentiment towards the stock market. This puts an important weighting on
behavioral market variables and in our opinion negates the concept of the
Efficient Market Hypothesis (EMH).
My background as a Chartered Financial Analyst has focused
almost exclusively on the fundamental drivers of a company and its stock price.
The basis of almost all of our investment ideas are rooted in the analysis of
corporate financials and company variables first and then expecting the stock
to trade based on the underlying corporation. Fundamental analysis is sound and
proven and is a staple in our investment decision making process. This type pf
analysis helps us establish which investments may be a great fundamental
endeavor but tells us very little about the near-term movement of the actual
stock itself.
Early on in my career I had been thwarted at times when a
seemingly fundamentally sound company didn’t have its stock cooperate in my
investment thesis. As my studies in behavioral finance expanded I started to
realize that fundamental analysis has its uses in pinpointing an appropriate
investment but did little to indicate the appropriate entry point to start
purchasing the stock. In short, fundamental analysis assisted in establishing which investments to make but did little
to provide insight on when to make
the investment.
As my education and research expanded into the field of
behavioral finance, it was only then did I realize the importance of investor
emotion and sentiment in the investment decision making process. It seemed to contradict
many years of teachings that surrounded the EMH but the more I learned about
the phycology of investing, the more enlightened I became. It allowed me the
opportunity to self-reflect on the shortcomings of focusing exclusively on one
field of investment theory. Understand that the use of fundamental analysis
still carries a strong influence on the decision making process, but through
the works of people like Amos Tversky and Daniel Kahneman it allowed me to
grasp a more rounded and holistic approach to portfolio management.
What is Fishbone?
The fishbone model was designed to assist in adding a timing
mechanism to the portfolio. The portfolio itself has core holdings that have
been introduced based on the fundamental merits of that particular underlying
investment vehicle. The Fishbone program allows us to “trade around” our core
position to insert portfolio protection when the market trends are unfavorable
to the portfolio. It attempts to capture the investor emotion / sentiment part
of the equation that if left unchecked can damage even the highest quality
fundamentally derived portfolio. The name Fishbone may appear odd but it was
given its name by the way it functioned.
While conceptualizing and back-testing the theory, it
initially started on a large white board and was a series of “if-then”
functions. If the first variable was met, then the model would progress in a
straight line to the next variable. If it failed the first variable it would
splinter off into a non-investment criteria.
We completed a twenty year back-test and found that using
the Fishbone model indeed offered statistically significant results that indeed
enhanced the return of our core fundamentally driven portfolios.
Fishbone Assumptions
Like many other of our quantitative investment theories this
one comes with a set of assumptions that we need to believe hold true in the
capital markets today.
Assumption #1 – Mean Reversion: What is irrational will soon
become rational. Bubbles do exists. There will be times when an investment is
profoundly over or under valued based on fundamental analysis. This can create
outlier opportunities. The concept of mean reversion is of the utmost
importance in our investment methodology. The entire market is a mean-reverting
mechanism and finding those outlier opportunities offers the greatest potential
for capital appreciation in our view.
Assumption #2 - Overconfidence: We as investors will never
be smarter than the whole of the market. That is a key element to understand
and respect. Thus the second assumption is that investors are over-confident in
their investment abilities. This is a straight forward assumption but very
difficult to quantify in practice. Knowing that investor overconfidence (also
framed as investor under-reaction) can take stocks and markets to new highs
well after the fundamental picture has deteriorated to the point of leaving
even the most sophisticated fundamental analyst scratching their head. I
attempt to overcome this behavioral shortfall by keeping a healthy respect for
the information that the market provides and if a trade or investment isn’t
working as anticipated, I don’t wait around for the market to prove me right.
In aggregate the Fishbone directional trading probability is right almost 62%
of the time. That means it is wrong 38% of the time. Quickly surveying the
investment landscape and realizing when one of those 38 percenters have been
introduced to the portfolio and eliminating the threat quickly is paramount to
portfolio performance. I’d rather take several smaller losses and admit a
miscalculation than have a few holdings deteriorate the gains in the portfolio
as I stubbornly wait for the market to wise-up to my way of thinking. That
doesn’t usually end well.
Assumption #3 – Overreaction: As a result of assumption #2,
when it finally comes to light that investors had been wrong in their highly
confident investment projections and the market moves against them, there are
at times an over-reaction to the new market dynamics. Highly volatile and large
price swings can be a result of this phenomenon. This is a condition that I
think I struggle with the most. Having the courage and discipline to remain in
control and adhere to a contingency plan in the face of extreme market turmoil
is difficult. As an investor, I set out to battle through emotional
shortcomings when the market dynamics become excessively turbulent. I haven’t
always succeeded in the task but the lesson hasn’t been lost and through
self-reflection I hope to better control this aspect of portfolio management.
Assumption #4 – Herd Mentality: Market participants will formulate
patterns and procedures that become a self-fulfilling prophecy. This herd-like
behavior from market participants is what allows technical analysis to flourish
in my opinion. Why is it that certain patterns and trends tend to hold so
often? The greater a specific pattern or trend is recognized by a group of
investors the more relevant it becomes. Trend analysis is a dominant trait in
the Fishbone model.
Fishbone Model
The Fishbone model attempts to recognize oversold
opportunities (negative sentiment) in an up-trending market (positive
momentum). It also attempts to find overbought opportunities (positive
sentiment) in a down-trending market (negative momentum).
To track momentum we incorporate the distance between the 20
and 50 day moving average (DMA) and the 50 and 200 DMA. We also incorporate the
moving average convergence divergence (MACD) histogram using the MACD daily variables
60, 130, 45. When aggregated together it produces a bar chart that seeks a mean
reverting zero balance. The outer bounds are infinite so the further out the
indicator ventures from zero (+/-) the greater the momentum reading. An increasing
figure represents positive momentum and a declining figure represents negative
momentum. The figures below represent the Fishbone momentum reading back to the
year 2007.
To track the shorter-term sentiment within the longer-term
momentum profile we use a combination of two oscillators. The relative strength
indicator RSI (5) and fast stochastics %K (14). This is an oscillator with the
outer bounds of 0 to 10. Those investments that exhibit a reading of 8 or
better are considered overbought and those investments with a reading of 2 or
less are considered to be oversold. The following graphic shows the Fishbone
oscillator going back to the year 2007.
While the Fishbone model was designed and tested for use in
an established portfolio for the purposes of portfolio protection or
enhancement, we launched the model as a standalone investment vehicle and have
funded it for the purposes of tracking and monitoring its success or failures.
We will be releasing the quarterly results of the model as we progress. While
back-testing is important for establishing conceptual integrity, only through
actual investments and the building of a track record will the execution of the
model be proven. In the model we trade stocks, ETF’s and options on stocks and
ETF’s. We do not allocate more than 5% of the total portfolio to any one single
idea and are sector agnostic in our equity selection. We do not venture outside
companies that reside in the S&P 500. We use a systematic and objective
approach to selecting which securities will go in the portfolio but keep a
subjective eye towards miscalculation and a low tolerance for positions that
are quickly proven to be a net negative to the portfolio (tight stops).
Bottom Line: The
Fishbone model was created to focus on the investor phycology part of the
investment decision-making process. It combines several behavioral rules and
establishes short and long term parameters to find investment opportunities
with the highest likelihood of success. We strive to buy securities with
positive long-term momentum but negative short-term sentiment. We will short
securities with negative long-term momentum but positive short-term sentiment.
Joseph S. Kalinowski, CFA
Additional Reading
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This analysis should not be considered investment advice and
may not be suitable for the readers’ portfolio. This analysis has been written
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