As investors, we’re all on a quest for that one secret or tool that can give us an advantage to improve our returns, minimize our risks and do it all easily and automatically.

Can Computer Software Create Super Portfolios?

Yet that secret has been hidden in plain sight for a long time, and the tool is most likely sitting on your desk right now.

Selecting strong stocks with wide economic moats, purchasing them at a price to ensure a sufficient margin of safety, diversifying based on low correlations, allocating money using the Sharpe Ratio, and rebalancing when necessary is the key to achieving superior returns with lower risk over the long term.

And while many people are intimidated by the stock market or think it’s in their best interest to hand over their money to the big banks and mutual fund companies, the truth is, your computer and a proven software package can give you far better results than what most investors are receiving today.

No matter what your level of investing experience, implementing the basics is essential to your portfolio’s well-being. It gives you the chance to transform your current mish-mash of randomly chosen stocks and mutual funds into a cohesive, efficient and effective machine for building long-term wealth in the stock market.

And it frees you from the chains of high fees, charged by big banks and fund companies, forever.

But can a computer program really pick stocks, create super portfolios and do all the other things necessary to successfully build wealth?

Fortunately the answer is, “Yes.”

Stock picking, unlike writing a book or understanding natural languages, is deterministic. In other words, given the correct data and a suitable algorithm, a computer can be instructed to construct an effective portfolio. There are no vague descriptions or multiple interpretations. You don’t need human-like intelligence or wisdom.

Rather, a handful of concrete rules and accurate financial data are all that’s required. Once you’ve got these two things in place, you simply repeatedly apply the rules to the data over and over again until a strong, well-diversified portfolio pops out.

And the good news is that the rules have already been developed and proven by some of the brightest investment minds to ever walk the planet: Benjamin Graham, Warren Buffett, John Maynard Keynes, Philip Fisher and Charlie Munger, to name just a few.

Over the course of decades, these men have tested their theories and made large sums of money implementing them. They are the best of the best.

Of course, decades ago, finding the required data was a very difficult task. And even with the data, analyzing it in a timely manner was almost impossible. Today, however, even a low-powered computer with an internet connection can find stocks and construct better portfolios than the professionals, with their large research staffs, could have done just a few decades ago.

As an example, let’s assume there is a universe of about 9,500 stocks trading on U.S. exchanges.

Since we’re not interested in penny stocks or most companies trading over the counter (OTC), we can quickly narrow that number down to about 7,000. Now it gets interesting.

Graham, Buffett and others gave us definite rules to determine a stock’s fundamentals and economic moat strength. For example, if a company’s Return on Equity (ROE) is greater than 30%, then that’s a good sign. Similarly if Net Income has grown consistently over the past 5 years, that’s another good sign. And if Cash Flow has also continually grown over the last 5 years, that’s yet another good sign.

And there are more such rules we can use; although one individual rule’s result doesn’t tell us too much about a particular company, all the results taken together provide an amazingly accurate picture of a stock’s strength.

As you can imagine, if you didn’t have a computer with software that could access these data, it would be a nightmare trying to determine whether a company’s ROE was greater than 30% or whether its Cash Flow had grown in the past 5 years. And if you had to do this for 7,000 stocks, it’s highly improbable you’d be able to do it without introducing errors, let alone do it at all.

And that’s where the computer comes in. Computers are very good at such tedious and repetitive tasks. And, as long as the software’s algorithm is correct, they perform error-free.

So a computer running the right software can very quickly download the required data for our 7,000 stocks and apply the rules on each stock’s data.

At any given time approximately 1.5% of stocks will pass the rules Buffett, Graham and the others developed. So if we analyze 7,000 stocks, about 105 will be returned – usually in less than 5 minutes using a high-speed internet connection.

That’s quite amazing. In the old days this same task would have taken scores of professional analysts months to complete.

But we’re not done yet.

Just because a stock has been identified as fundamentally strong with a wide economic moat, it doesn’t mean it’s a good value. Even stellar stocks can be overpriced.

However Buffett and Graham come to the rescue once again. They defined further rules that show us how to calculate a stock’s intrinsic value using readily available data such as Earnings per Share, Dividend Yield and Estimated Growth Rate.

So once again our investment software can apply some rules to specific data items, for each stock, to determine its intrinsic value. Then a specified margin of safety combined with the stock’s current price can be used to determine whether the stock is fairly valued, undervalued or too expensive.

Using this valuation algorithm we generally find about 25% of our fundamentally strong stocks will be either fairly valued or undervalued (75% end up being too expensive).

Going back to the 105 solid stocks we found earlier, that means about 26 of them would be considered good buys at their current prices and should be considered for our portfolio.

Think about that for a moment. From an initial universe of 9,500 stocks, we were able to immediately reduce that number to about 7,000 and then further reduce that number to 105 and finally come up with 26 super stocks selling at fair or bargain prices. And using our computer, software and the internet, we were able to do this in about 5 minutes.

But we’re still not done.

Buffett has stated that concentrated portfolios will usually outperform. He’s said holding 5 to 10 stocks is the way to go. The caveat being, those stocks must be exceptional and properly diversified.

As you’ve seen, we’ve covered the first part and come up with 26 exceptional stocks. So let’s look at the second part, being properly diversified.

We want the individual stocks in our portfolio to behave differently from one another. So when one is going up, the others aren’t doing the same thing. The mathematical term for this is called, correlation. We want the stocks in our portfolio to have low correlations or be uncorrelated.

An easy way to get this result is to select stocks from very different industries. For example, consumer goods stocks usually have low correlation with technology stocks.

However a better way is to actually calculate the correlation between each stock using historical data, usually going back 5 or 10 years. As you can imagine, doing this by hand for even 26 stocks is not feasible. However a computer can do this in the blink of an eye (well, perhaps 10 or 20 blinks).

The point is, we can have our software download 10 years of historical data for each of our 26 stocks and calculate the correlations. Then we can simply pick 5 or 10 stocks with the lowest correlations between them.

And just like that we’ve constructed a well-diversified portfolio of exceptional stocks with wide economic moats selling for fair, or bargain, prices. And if you were to stop there, nobody could blame you. Your portfolio would be better than the vast majority of investors’ out there.

However our software can help us do even better.

Rather than throwing an equal amount of money at each stock, we can use the Sharpe Ratio (which is a measure of risk-adjusted performance) to allocate our funds a bit more intelligently.

Stocks with better risk-adjusted performance should receive more money than stocks with worse risk-adjusted performance. I won’t go into the actual Sharpe Ratio calculation here (you can look it up via Google if you’re interested), but it’s a formula that uses a stock’s expected return and its standard deviation.

Our software can easily apply this formula to each of our selected (5 to 10) stocks and tell us exactly how much money to allocate to each one. So if Stock A has twice the historical risk-adjusted performance as Stock B, we should allocate twice as much money to Stock A as to Stock B.

That’s the allocation phase. And we’re almost there. But we still have one more step.

Before we continue, however, let’s review what our software has done for us so far.

  1. It’s selected 5 to 10 exceptional stocks with wide economic moats selling for fair or bargain prices from an initial universe of 9,500 stocks.

  2. It’s ensured those stocks are well-diversified by using correlations.

  3. And it’s allocated our money to each of these stocks on a risk-adjusted basis.

It’s also done all of this automatically and in very little time.

So what’s left?

The final piece of the puzzle is to rebalance as necessary.

Remember when we diversified based on low correlations? That was an important step. Not only because it reduces those wild and terrifying gyrations in value at the portfolio level, but also because it gives us the opportunity to automatically buy low and sell high.

And we do that through rebalancing. Of course software can do this for us too.

It can continually monitor our portfolio and rebalance when necessary. All automatically.

And that’s why software can not only pick strong stocks, but it can also construct super portfolios and manage them with very little time and effort on your part. So you spend less time but receive far better results.

If you’re not already doing so, take some time to research which software fits your investment style and goals, and then put your investments on automatic pilot and start reaping the huge benefits that come your way.

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