Why the Magic Formula Rebalances Its Stock Portfolio Annually
Summary
The note explains why Joel Greenblatt’s Magic Formula uses a roughly one-year holding period. It cites the book’s tax rationale: in taxable accounts, selling losing positions just before the one-year mark and winners just after it can give losses short-term treatment and gains long-term treatment, subject to the tax rules described in the source. The answer also argues that shorter intervals add time, transaction, and tax costs, while much longer intervals delay responses to changes in company quality or rankings. Staggering purchases across two or three months is presented as a way to add highly ranked stocks more frequently.
The note lists studies reporting favorable long-term results in several markets, alongside short-term underperformance and increased volatility in some periods. It does not assess those studies in depth: the respondent says they have not independently examined post-publication performance. The reported findings are therefore context, not proof that the strategy will continue to outperform or that one annual schedule is optimal for every investor.
Key ideas
- The one-year holding period is presented partly as a way to qualify stock gains for long-term tax treatment.
- Shorter holding periods may increase transaction, time, and tax costs for a long-term strategy.
- Rebalancing too infrequently can delay responses to changes in company quality and Magic Formula rankings.
- Staggering purchases over several months can add highly ranked stocks at different points in time.
- The cited market studies report mixed evidence, including long-term outperformance in some settings and volatility or short-term weakness in others.
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Full text
# Magic Formula Holding Period # Magic Formula Holding Period In Joel Greenblatt's Magic Formula why is the holding period one year? Why not rebalance the portfolio once each two years? Or three years? ## Answer by AKdemy (score 3) https://quant.stackexchange.com/a/74184 Quoting from the book > Holding stocks for one year is still fine for tax free accounts. For taxable accounts, we will want to adjust that slightly. For individual stocks in which we are showing a loss from our initial purchase price, we will want to sell a few days before our one-year holding period is up. For those stocks with a gain, we will want to sell a day or two after the one-year period is up. In that way, all of our gains will receive the advantages of the lower tax rate afforded to long-term capital gains (a maximum 15 percent tax rate under federal guidelines for stocks held more than one year), and all of our losses will receive short-term tax treatment (a deduction against other sources of income that otherwise could have been taxable at rates up to 35 percent). - 1 year is favourable for tax reasons - Below one year; time, transaction costs, and tax expenses make it impractical for a long-term investment strategy. - Above one year, apart from giving up the favourable tax treatment, would mean you don't rebalance very often and hence don't react to changes in the market (quality or ranking of companies). In his book, he compares his strategy to a strategy that rebalances every month for example. So generally, you do not want to wait too long with rebalancing. That's also the reason why he suggests spreading your purchases across two or three months. That way, you more frequently add the best ranked stocks over time. EDIT I cannot really answer the question how the magic formula performed after its publication because it is not related to my work and I have not spent time looking into this on my own. However, a quick google search reveals that Wikipedia lists a few studies with generally favourable results (references with [*] can be found in the Wikipedia link): - A critical look at Greenblatt's Magic Formula: Between July 2003 and December 2015, the Magic Formula strategy returned an annualised 11.4% (Sharpe ratio 0.60), versus 8.7% for the S&P500 (Sharpe ratio 0.54). - A 2016 study from the stock market in Finland found the magic formula "yields higher risk-adjusted returns on average". The authors also proposed that a modified form of Greenblatt's strategy, additionally emphasizing companies with better than average free cash flow, was best suited to bull markets.[3] - A 2016 study found possible confirmation of Greenblat's formula in Brazil's stock market, but cautioned "we could not assure with a high level of certainty that the strategy is alpha generator, and that our results were not due to randomness."[4] - A 2017 study from the markets in Sweden found application of the Greenblatt formula resulted in long-term outperformance of market averages in the periods 2005 to 2015, and 2007 to 2017. The authors also found the "magic formula" was also associated with short-term underperformance in some periods, and significantly increased volatility.[5] - An analysis of the Hong Kong stock market from 2001 to 2014 found Greenblatt's formula was associated with long-term outperformance of market averages by 6-15% depending on company size and other variables.[6] - In 2018, a paper presented at a professional conference found validation for the Greenblat formula in the Chinese stock market.[7]
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.