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Investing Long Term Using the Quillian Model 

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by James M. Quillian, Securities Analyst & Portfolio Manager

When the stock market bubble burst a few years back, individual investors lost millions of dollars. Long term investors were especially hurt. As the decline began investors all across the country could be heard repeating the mantra “I am a long term investor. I am not concerned when the market goes down” These words were often spoken as a means of appearing to take the high ground as if people doing the selling were being reckless.

Most investment losses can be avoided by thinking though a common flaw in the in the investment reasoning process.

More often than not, investors believe that because stock averages continue rising over time, most stocks also rise over time.  Decade after decade, stock averages have indeed continued to make new highs. The total value corporate capitalization, or stock, also continues to rise. However, most individual stocks eventually go down and never recover. Figuring this out doesn’t take a lot of analysis. Right now a stock screener on a popular web site turns up 4709 stocks that are trading below $5.00 per share. The same screener turns up 1241 stocks trading between $5.00 and $10.00, 2074 between $10.00 and $20.00 and  3153 stocks trading at over & 20.00 per share.  The majority of stocks did not start out trading at such low prices. They all traded much higher at one time.  Only a few low priced stocks will ever recover.

During the dot.com debacle, the multitudes of investors unwittingly held on to their stocks believing they were going to be rescued by the long term. The long term for the majority of stocks always has been and always will be something resembling a graveyard.

An investor who anticipates ahead of time that less than half of all stock purchases turn out to be profitable if held indefinitely is in a better position to put together a successful investment program than someone who does not know what to expect.  Most serious stock market losses occur not because of a lack of financial sophistication, but because of simple errors in judgment.  Quillian & Taylor suggests building a portfolio using the Quillian Model. The Quillian Model as described below provides individual investors with a a logical framework of expectations.

The Quillian Model

• Only buy stocks in up-trends or in recognizable positive technical patterns.

Think long term but understand what actually happens over the long term.

For the example, consider long term to be ten years.

According to the  Quillian  Model:   

• If 20 stocks, all in up trends, are picked at the beginning a long term period. (10 Years)

• 5 will continue moving up at the same rate for the entire period.

• 9 will eventually falter and move sideways or slowly down or up.

• 6 will reverse direction and end up losing money.

Secondly, 

• Over time, portfolio value increases will be the result of a minority of the stocks that make up the portfolio.

• Portfolio performance is greatly enhanced if money is appropriately rotated out of poorly performing stocks and into stocks which are steadily advancing.

The Quillian  Model is not a guarantee that the future will unfold in a certain way but instead a reasonable expectation that is based on observations of stock market history. 

The exact numbers might be different from those in the example but the principle always applies. Over time, the majority of investment ideas turn out to be bad.  The successes of a few stocks, however, end up more than making up for losses incurred in the others.  Portfolio performance is greatly enhanced if the stocks that begin to falter are eliminated and replaced with new stocks which are already in up-trends.  The Quillian Model is not a ridged prescription of any kind but as a logical expectation.  In order to be truly successful, any long-term investment program must be adjusted in accordance with the simple principal described in the Quillian Model.  Stocks are good long-term investments but one must realize that a minority of stock picks turn out to be profitable in the end.  Buy and hold is the best strategy, but only when over time non-performing stocks are replaced. 

Investors are invariably hurt when they expect from the stock market more than the stock market is capable of delivering. The Quillian Model provides portfolio managers with a reasonable table of expectations. 

Often the performance of stock averages is sited as evidence that stocks are a good long-term investment.  What is never mentioned is that the stocks which make up the averages are constantly being changed. Looking at a 50 year chart of the Dow Jones industrials makes an impressive case for a buy and hold strategy. But what kind of performance would the Dow Jones Industrials have had if none of the Dow stocks of the 1930 list had been replaced?  Three stocks have been rotated out of the list just since since 1997. Look in the table below and observe how the composition of the Dow Jones Industrials has changed over time. 

Composition of the Dow Jones Industrials at Selected Time Periods  

Here are a few more helpful tips:

Give up naive ideas about risk. Many investors automatically assume that risk is reduced by sticking with low P. E. stocks or stocks of large well established companies. High dividends are often seen as indications of safety. No such ideas hold water when empirical evidence is examined.

Understand the limitations of  fundamental analysis.  New investors often delude themselves into thinking they know something special about a stock, and the rest of the world will eventually catch on, and the stock will go up. That kind of reasoning only works on rare occasions. The speed with which information spreads through the investment community is almost beyond comprehension. Novice investors also typically believe that insiders and professionals have superior information. They have an advantage only occasionally and in isolated circumstances. The financial realm unfolds faster than even the brightest mind can decipher information. Fundamental analysis is valuable for answering basic questions concerning the financial stability of a company, and understanding the broad scenario in which a company operates. Fundamental analysis can successfully be used to eliminate stocks from consideration. For example, if a stock is in a strong up-trend but is in horrible financial condition, it might make sense to choose another stock instead.  Fundamental Analysis will do little to indicate the future direction of a stock price.