Data processing: financial – business practice – management – or co – Automated electrical financial or business practice or... – Finance
Reexamination Certificate
1999-07-27
2001-11-13
Millin, Vincent (Department: 2164)
Data processing: financial, business practice, management, or co
Automated electrical financial or business practice or...
Finance
C705S035000, C705S037000, C705S038000
Reexamination Certificate
active
06317726
ABSTRACT:
FIELD OF THE INVENTION
The invention is in the field of using a computer to select corporate stocks for investment.
BACKGROUND OF THE INVENTION
Knowing how a particular investment strategy performed historically gives one the vital information one needs on its risk, variability, and persistence of returns. Before the commencement of the inventor's work, there was no widely available comprehensive guide to which strategies are long-term winners and which are not. The inventor had access to the historical S&P Compustat database of United States stock market information: forty-three years of results for Wall Street's most popular investment strategies.
It took the combination of fast computers and huge databases to prove that a portfolio's returns are essentially determined by the factors that define the portfolio. Before computers, it was almost impossible to determine what strategy guided the development of a portfolio. The number of underlying factors (e.g. price-to-earnings ratio, dividend yield) that an investor could consider seemed endless. The best one could do was look at portfolios in the most general ways. With computers, one can also test combinations of factors over long periods of time, showing what one can expect in the future from any given investment strategy.
History shows that traditional active management does not work. The majority of actively managed funds do not beat the S&P 500. Passive index fund managers have seen their assets rise as a result, from $10 billion in 1980 to over $250 billion in 1990.
There is no product similar to or the same as the method or apparatus of the present invention. Since the magnitude of the sums involved and the complexity of the relevant investment information, it is very desirable to use an objective rule-based strategy and system for automating, to the extent practicable, the conduct of this decision-making.
SUMMARY OF THE INVENTION
The data presented by the inventor proves that the market clearly and consistently rewards certain attributes (e.g., stocks with low price-to-sales ratios) and clearly and consistently punishes others (e.g. stocks with high price-to-sales ratios) over long periods of time. A paradox remains: tests show high return predictability, but 80 percent of traditionally managed mutual funds fail to beat the S&P 500. Models beat human forecasters because they reliably and consistently apply the same criteria time after time.
Stock market decisions and portfolio constructions are served by a methodical scientific method. Certain rules help in this process. First, all models must use explicitly stated rules without ambiguity or allowance for a private or unique interpretation of the rule. Second, the rule must be stated explicitly and publicly so anyone with the time, money, data, equipment and inclination can reproduce the results. Third, someone using the same rules and the same reliable database must get the same results. Fourth, the results must be consistent over time; long-term results cannot owe all their benefits to a few years. Fifth, the rule must be intuitive and logical and not be derived from the data.
The inventor used the S&P Compustat Active and Research Database from 1950 through 1994. The inventor used certain methods to evaluate how different rules for constructing portfolios worked over these periods. Certain choices were made regarding size of the portfolio (50 stocks for most strategies), market capitalization (generally, requiring a minimum of $150 million), and annual rebalancing.
Size of the portfolio. As evaluated, stock portfolios contained 50 stocks, some of the portfolios in this application contain 10, 25, 30, 40 or 50 stocks. Researchers J. L. Evans and S. H. Archer found most of the benefits of diversification come from as few as 16 stocks. One wants to avoid holding too many or too few stocks. Larger or smaller portfolios are within the scope of the inventor's invention.
Market Capitalization. The inventor primarily studied two groups. The first stock group includes only stocks with a market capitalization in excess of $150 million (adjusted for inflation); it is called All Stocks throughout this application. The inventor chose $150 million after consulting a trader at a large Wall Street brokerage who felt it was the minimum necessary if he was investing $100 million in 50 stocks in 1995. This figure avoids focusing on tiny stocks and focuses only on those stocks which a professional investor could by without running into liquidity problems. A stock with a market capitalization of $27 million in 1950 is the equivalent of a $150 million stock at the end of 1994 and each is the equivalent of a stock with a market capitalization of $172 adjusted for inflation. The second stock group includes larger, better-known stocks with market capitalizations greater than the database average (usually the top 16 percent of the database by market capitalization); it is called Large Stocks throughout the application.
Annual Rebalancing. The portfolios studied are constructed and rebalanced annually. Stocks are equally weighted with no adjustment for other variables. For example, if $1,000,000 is invested in 50 stocks, a $20,000 investment is made in each stock. Dividends are re-invested in proportion with the original proportions. At the end of the year, all of the stocks may be sold and replaced with another fifty stocks that meet the criteria of the strategy. Throughout the application, rebalancing refers to this process. Of course, for tax purposes, an investor must be careful in rebalancing that one does not unnecessarily sell and reacquire shares of stock in an existing portfolio when performing the rebalancing. A year was chosen since it is long enough to minimize effects of commissions and costs of rebalancing the portfolio. A term as long as two years or as short as three months could be used as the period after which one rebalances the portfolio in accordance with some embodiments of the present invention.
Sharpe Ratios. The inventor uses the well-known Sharpe ratio of reward to risk, with higher numbers indicating better risk-adjusted returns. To arrive at the Sharpe ratio, take the average return from a strategy, subtract the risk-free rate of interest, and then divide that number by the standard deviation of return.
TABLE 1
Standard
Average
Deviation
S&P 500
14.25%
12.01%
T-Bills
6.15%
2.07%
S&P 500
8.10%
11.68%
Minus T
Strategy
19.06%
24.37%
T-Bills
6.15%
2.07%
Strategy
12.91%
24.75%
Minus T
See Table 1.
The risk-adjust return for the S&P 500 equals 8.10% divided by 12.01% or 67.44.
The risk-adjust return for the strategy equals 12.91% divided by 24.37% or 52.97.
Market Capitalization Matters. A comparison of All Stocks (stocks with a market capitalization of more than $150 million) and Large Stocks (stocks with a market capitalization higher than the database average) reveals that size matters. All Stocks outperformed Large Stocks.
For purposes of simplicity in this application, the yield of a $ 10,000 investment over the 43 years (or the 40 years for those strategies using 5-year factors) in millions and the resultant Sharpe Ratio is presented. The portfolio is rebalanced annually. Stocks are equally weighted, all dividends are reinvested, and all variables such as common shares outstanding are time-lagged to avoid look-ahead bias. For those interested in viewing more of the underlying data, the inventor suggests that the reader consult his commercially available book,
What Works on Wall Street
(Author, James P. O'Shaughnessy. Published by McGraw-Hill, 1997).
A more detailed analysis of how capitalization affects stocks' performance follows (in millions ($1M), from an initial investment of $10,000 invested over 43 years) in Table 2 and Table 2A.
TABLE 2
Category
$1M's
Sharpe Ratio
All Stocks
1.80
47
Large stocks
1.00
45
S&P 500
1.00
44
Cap < $1b
.80
40
500M < cap < $1b
.75
39
250M < cap < 500M
1.30
45
$100M < cap < $250M
1.30
42
$25M < cap < $100M
1.70
41
Cap < $25M
29.10
57
TABLE 2A
Category
Elman & Associates
Millin Vincent
Netfolio, Inc.
Pwu Jeffrey
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