For those unfamiliar with John's work, he is best known for being the founder of stock-screening website Validea.com. John is also the author of "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies" and a regular columnist for RealMoney.com, Forbes.com and MSN's Strategy Lab. John also maintains the investing blog The Guru Investor which you will find among the blogs I read.

We will cover a wide variety of topics in this Q&A and we hope you find it as helpful and enjoyable as we have in preparing it for you!

Q&A With John Reese

Kirk:  Hi John. Welcome to the Q&A! We are excited to have you here so we can learn more about you and your perspectives and approach.

John Reese:  Thank you Charles. I'm also very excited to be speaking with you and I appreciate you putting this together. I hope I can offer up some valuable thoughts and insights from my investing experiences and research that your readers can learn a little bit from.

Kirk:  Let's start at the beginning. When and how did your interest in the market begin early on?

John Reese:  I first became interested in the stock market at the age of thirteen when I became curious, then fascinated, by reading each weekly issue of Value Line that my father subscribed to and then trying to figure out which combination of Value Line's ratings and screens would help pick the best stocks. Around that time, I also began playing the 3M bookshelf game "Stocks and Bonds" and became quite good at it, reinforcing my interest in stocks and investing.

Kirk:  How did those early experiences transition into a lifetime career?

John Reese:  When I went to MIT, my main interest was learning everything I could about technology and computers. As part of this interest, I joined the MIT Artificial Intelligence Laboratory, where I learned how to extract wisdom from books and incorporate that knowledge into smart computer programs. With the encouragement of one of my professors, J. Licklider, I began to think about how I might make a smart computer program to pick stocks. However, that was perhaps one of ten diverse projects that I was seriously spending time on (the others ranging from non-drug treatment of migraine headaches, to the first microprocessor-controlled system for office building HVAC systems to save energy and money, to electronic speech recognition, to a computer controlled windrower that could automatically harvest rows of grains without being ridden by a human.) I actually brought several of these projects to fruition, but the program for picking stocks ended up on my incubation list, where it was to lay dormant for many years.

After graduation, I went on to a career in engineering and business, getting my MBA at the Harvard Business School and working in the telecommunications and personal computer industries. I eventually founded a business focused on computer networking. It was the sale of this company many years later that retriggered my interest in the stock market - trying to figure out how to invest the cash that I received from the sale of my company. I had read many investing books, but it wasn't until I read Peter Lynch's One Up on Wall Street that I had an "aha!" moment. Here was someone with 1) a proven track record, who 2) in his book had publicly disclosed the stock-picking strategy that made him successful, and who 3) had a strategy with a substantial, clearly described quantitative portion. I thought that I could extract the wisdom from his book, and create a computer program to analyze any stock of my choice and tell me whether Peter Lynch would have a strong interest in it -- and why or why not.

This approach proved to be extremely successful and time efficient. I went on to identify more than a dozen investing legends (after reading hundreds of investing books and research papers) whose works met the three criteria I just mentioned. Then I implemented Artificial Intelligence "knowledge bases" for each one -- that is, I created computer models that evaluated stocks using each approach. So, by entering just the ticker symbol of a stock that caught my attention, I could almost instantly get the opinion of twelve investing legends on the stock.

This development happened near the beginning of the Internet era, and, with my handpicked team, I went on to offer access to these models on the Internet at Validea.com.

The extensive investing research that I had done, plus the excellent track records of stock portfolios picked by each of my AI gurus, resulted in quite a few individuals asking me to manage their money. I thus created Validea Capital Management, which, along with Validea.com, became my full-time passion and my new career.

Kirk:  Do you consider yourself a trader, investor or something in between?

John Reese:  I consider myself an investor. More specifically, I am a fundamentally based systematic investor and the strategies I use to select stocks are based off of the approaches outlined by some of history's best investors. Peter Lynch, David Dreman, John Neff, Ben Graham, just to name a few, have shared their investing methods in books and papers, and I've captured these approaches in the Validea system. While each strategy is very different, they are all investing methodologies that determine whether or not the stock of a company is a good value based on the underlying fundamentals of the company. Income statement, balance sheet, cash flow, P/E, P/S and P/CF are just a few of important fundamental variables that my system looks at when analyzing and selecting stocks.

Kirk:  Tell us a little about what you're doing right now and your approach toward the market?

John Reese:  At the core of my investment philosophy is the belief that the fundamental strategies of some of history's top performing investment managers offer a foundation for superior stock selection, and implementing these techniques in a disciplined, unemotional and systematic manner can lead to long-term market outperformance.

I understand there's a lot baked into that statement, and we'll have the opportunity to dive into the key components this framework because I think investors can learn and grow from understanding each part of it.

But really it's this philosophy that sits the heart of the various investment-related businesses that I've founded.

The first business is Validea.com, which is my independent investment research firm that offers stock research and analysis, screening tools, and model portfolios based on twelve guru-based strategies. Validea is currently offered only in the United States, but we are currently working on versions for both the Canadian and South African markets with partners in those countries.

The second business is my registered investment advisory firm, Validea Capital Management. For investors who are looking for portfolio management, I offer separately managed accounts through Validea Capital and I also sub-advise two mutual funds in the Canadian market - the Omega Consensus American & International Equity Funds - using my systematic strategies.

Under Validea Capital I also have a partnership with Jon Markman, a leading columnist for MSN Money and a very successful newsletter writer. Through this new offering - Markman Portfolios - investors can now invest in the privately managed portfolios offered by Jon Markman through Validea Capital. This is an exciting growth opportunity for us.

Kirk:  What does your weekly routine consist of right now?

John Reese:  My weekly routine will vary depending on what we have going on but in general I would say that about 60-65% of my time is spent on Validea Capital related responsibilities, including working directly with new and existing clients, monitoring portfolio positions, working on new investment models and other things to help grow the advisory business. The other 35-40% of my time is spent on things related to Validea.com, whether it be editing the weekly newsletter, testing new model portfolio ideas or working on ways to grow the business.

Kirk:  Let's talk about Validea Capital Management which serves both high net worth individuals and institutions. What do you and your firm offer that stands out from the rest?

John Reese:  Validea Capital is a SEC-registered investment advisory firm. Currently, we manage or sub-advise approximately $145 million between our US-based advisory business and two mutual funds in the Canadian market. My private clients have the ability to invest across eight different managed account portfolios. Each of these portfolios is constructed using the various quantitative strategies I run.

Validea Capital stands out in my opinion because it follows a systematic investment approach that relies on a combination of strategies that have proven to work well over long periods of time. The 12 models that I run on Validea.com have each proven themselves successful over the long-term, but like all models, they won't outperform all the time. I have found that by combining them together using proprietary systems I have developed, I can smooth out many of those underperforming periods by mixing models that do well in different kinds of markets. That ability to combine models with outstanding long-term records in their own right together into professionally managed portfolios is what makes us stand out, in my opinion.

Kirk:  The vast majority of professional money managers do not consistently beat the S&P 500 over multiple time frames which is why so many have advocated using passive low-cost indexed funds versus active management strategies. Why do you think you can consistently succeed and offer value when others have so miserably failed?

John Reese:  The short answer to that is I think we can succeed because we follow models that have already shown that they outperform the market over long periods of time. Validea Capital offers a set of quantitative strategies that are highly disciplined and unemotional. The strategies we run are managed in a consistent and repeatable way. This is one of the key advantages of a quantitative investment approach. Fund managers and research staff change over time and as a result of those changes an investment approach that contributed to performance of a specific fund in the past may not be applicable in the future.

I also view size and style box requirements as constraints that hurt performance. The mutual fund industry is built around investment mandates, and I understand the value of knowing XYZ Fund is a large cap value fund or that ABC fund is a small cap growth fund, but in my view this detracts from long-term returns. I let my models roam free to find the top-scoring stocks, whether they are small, mid, large or mega cap. I don't restrict my strategies to one specific market cap size.

We also run concentrated portfolios at Validea Capital. We manage portfolios that hold between 20 and 60 stocks for our clients whereas the average mutual fund holds about 140-150 stocks. There is research that supports the outperformance of concentrated funds, and I believe that once you hit 30-40 stocks you have removed most of the firm-specific risk from the portfolio.

We also review our portfolio holdings on a set monthly basis. Actually, we follow a 28-day cycle. Once every 28 days, we review the portfolio and remove the stocks that have fallen in score (that is, their score using my guru-based strategies), and replace those stocks with new, better scoring securities. We consider ourselves long-term investors, but we don't believe you have to hold individual stocks for the long term to be a long-term investor. Our belief is that you need to follow a consistent strategy for the long term, but should re-examine your portfolio on a set basis to make sure the best available ideas are in the portfolio. The individual holdings in your portfolio can thus sometimes change fairly frequently, if the fundamentals of those companies change, but the overall strategy you use to buy and sell stocks remains constant.

So I think what makes us unique is the combination of the investment strategies we run and the framework we've developed. While it's very difficult to outperform the market over time, I think that we have a distinctive approach that can continue to produce very good long-term results.

Kirk:  I see that Validea Capital offers 8 value-driven portfolios which seem to offer various different approaches - growth, value, market rotation, asset allocation, etc. How have these portfolio approaches performed over the past year, three-year, five-year and 10 year periods in comparison to the S&P 500?

John Reese:  Validea Capital has been in existence since 2005, so we are just completing our 5th year of managing actual money. We did run most of our models in a model portfolio environment prior to that and when those results are combined with the actual money management results, we end up with a 6+ year total history. All of our models have outperformed the market during the 6+ year period, but due to SEC performance reporting requirements, we don't like to quote actual figures without putting them in the context of a complete performance report with full information and appropriate disclaimers. Any investors interested in our full history can request to view performance by filling out a form on our web site Valideacapital.com or email us directly at info@valideacapital.com.

Kirk:  As a teaching example, can you pick one of these portfolios and show us how you create it?

John Reese:  Let me give two examples - our Consensus and our Select Blend portfolios. Both of these are portfolios I run for clients at Validea Capital.

The Consensus portfolio is a 50-stock portfolio that selects the issues with the highest degree of overlap from multiple top performing strategies. Using all of the guru-based models we run, we have created a ranking system that scores each stock in our universe. The strategies with the best long-term risk-adjusted return get a higher weighting in the overall model. So for example, if company XYZ obtains 100% score from our Graham, Lynch and Zweig models there is a good likelihood that this stock would be included in the Consensus portfolio.

Our Select Blend portfolio is a 60-stock portfolio that combines six different 10-stock models together. So in this portfolio, 1/6th of the portfolio is comprised of the top 10 securities from a particular strategy. The actual combination of strategies is done by looking at the correlation among our approaches. Our goal is to combine approaches that don't have a lot of correlation, so that we can reduce the risk and smooth out the returns.

Kirk:  Each of the portfolios are clearly different from one another. So, how do you find and match the best method/portfolio that is most appropriate for your clients and their objectives?

John Reese:  For each and every client that invests with us, I have a one-on-one call with them to get a better understanding of their risk tolerance, time horizon, investments outside of Validea Capital and anything else that is relevant in making an allocation decision. My overall objective in this call is to get a sense for the amount of risk they are comfortable taking and what their expected return goals are. I think these conversations help differentiate Validea Capital from others who aren't really customizing clients accounts.

Based on what comes out of that consultation, we mix and match various portfolios to help accomplish the best, most prudent allocation for the client. For example, for clients that are in retirement or nearing retirement and want to participate in stocks, but also want loss protection from a major market downturn, I would consider working in our Market Rotation portfolio and complementing that with one of our long-only portfolios for 20-30% of the investment. For someone who is comfortable with taking more risk and wants to maximize returns over an entire market cycle, I would consider combining a few of our long-only portfolios. As you might imagine, it varies from investor to investor.

Kirk:  It appears from the website that these approaches were created through "extensive historical testing." So tell us, how do you backtest and verify these strategies as being useful?

John Reese:  There are really two parts to our testing process. First, to even be considered for inclusion on Validea.com or in the Validea Capital investment management models, a strategy needs to have been either 1) tested extensively by its creator, or 2) have been developed by an individual with a long track record of outperforming the market. So for example, Joel Greenblatt's model, which is one that I follow on Validea.com, would meet the first of those two tests, and Peter Lynch's would meet the second.

After I select a model based on its own track record, I begin to look at it in a live model portfolio environment for a period of time before I will release it. I do this to ensure that what I see in real life is consistent with the historical results obtained by the gurus who developed the strategies. I have been running most of my models live since 2003 and the results I have seen have been consistent with the historical results that led me to select them. In a model environment, I am also able to look at how these strategies are correlated with each other, which is important for the creation of the Hot List portfolio on Validea.com and for the Validea Capital money management models. I have found that by combining strategies that have low correlation with each other, I can reduce risk without reducing returns.

Kirk:  Can you provide an example of your backtesting research so we can get a better idea of what you do in order to thoroughly backtest and verify a specific strategy?

John Reese:  The strategies I follow are all based on the extensive track records of their creators, whether it be through actual money management results, or their own back tests, so I don't back test from the perspective of verifying those results. The success of their creators allows me to rely on them. My back testing is more a function of finding ways to combine the individual guru models together in a portfolio context to limit risk.

In examining strategies that outperform the market over long periods of time, one of the things that becomes apparent is that despite having very impressive long term records, all strategies will have bad years. The benefits of combining strategies that use varying approaches comes in the fact that those underperforming years typically occur during different times for different types of strategies and therefore by combining them, you can get comparable returns, with less year over year fluctuations.

Kirk:  How do you recommend investors learn how to backtest their approaches?

John Reese:  I personally would recommend that investors follow the approaches of investors whose approaches have stood the test of time or have already been professionally tested, rather than trying to create their own. When I started Validea, I considered trying to create my own approaches and back test them, but I found that the pitfalls of such an approach were substantial, and I also found that there are many strategies out there that were created by investors with already proven long-term records. I feel as though picking one of those that fits your investment goals and risk tolerance is better than trying to re-create the wheel yourself.

Kirk:  In your experience, are there any traps investors should try to avoid when backtesting?

John Reese:  There are many. There are technical problems like availability of quality data, survivorship bias (which in laymen's terms means that you need to consider companies that were around at the time, but no longer are today when you test), data mining (continually changing the data until you get the results you want) and a variety of other issues exist. I think the major trap investors should avoid if they do try their own testing is one that is not often talked about, but is really important - discipline.

What I mean by that is that most investors, even if they find a great approach that works, won't stick with it when times get tough. This leads to them missing the inevitable bounce back and costs them dearly in terms of returns. So my best piece of advice is if you see bad years in your testing, don't dismiss a strategy because of it. I track some of the best strategies of all-time on Validea.com and they all have bad years. If the long-term record is in place, then staying the course through bad years will result in great long-term returns.

Kirk:  Most investors as you know are ill-equipped and/or may not be motivated enough to employ rigorous backtesting so they have to take a leap of faith based primarily on track records and past performance. In your view, how do investors go wrong in making that leap?

John Reese:  Investors are always attracted to the best performing strategies. They look at "what is working now" and extrapolate that performance out into the future. The first thing every investor should do is try to understand the underlying strategy they are interested in. They should ask themselves what contributed to this performance and then ask themselves if they understand it. If the answer to those questions is "yes", then the next question is does it seem like the process that obtained that performance is repeatable.

I am always wary when a potential investor contacts us because of our good performance only and doesn't take the time to understand our approach. The good thing for us is that most of our clients understand our approach, because they've either used the Validea.com research site or they've followed my commentary. As a result, they have some insight into how we are selecting stocks and they know that our portfolio management processes are highly disciplined, repeatable and consistent.

Kirk:  As you've mentioned, you've created quite a nice resource at Validea.com which tracks portfolios based on "Wall Street Legends." First, why did you come up with the idea of creating model portfolios based on the approaches of so-called market gurus versus other methods?

John Reese:  When I first founded Validea.com, it was a stock screening and analysis web site utilizing guru strategies. These core features are still on Validea, but what was lacking was a framework that showed investors that they could make money by following these approaches. Screening is a great way to find investment ideas, but I wanted to develop a feature that would make it even easier to follow and profit from these time tested methodologies. So in 2003 I created 10- and 20-stock portfolios for the first group of gurus I had on the site. This was a breakthrough for our company in many ways. The performance on these strategies has been outstanding, and it's shown thousands of investors that you can use these guru methods and principles in the context of managing a portfolio to produce market outperformance.

Kirk:  Who are the gurus you follow and why have you decided to follow these people versus others?

John Reese:  On Validea we run quantitative strategies based on books or academic papers by or about the individuals listed below. In most cases, the gurus have a long-term track record of success, have published a stock selection approach that can be quantified and is clearly defined, and carry some amount of name recognition and creditability in the investing world.

• Warren Buffett -- Patient Investor - based on "Buffettology"

• Martin Zweig -- Growth Investor - based on "Winning on Wall Street"

• Benjamin Graham -- Value Investor - based on "The Intelligent Investor"

• Kenneth Fisher -- Price/Sales Investor - based on "Super Stocks"

• Peter Lynch -- P/E/Growth Investor - based on "One Up on Wall Street"

• Joel Greenblatt -- Earnings Yield Investor - based on "The Little Book that Beats the Market"

• David Dreman -- Contrarian Investor - based on "Contrarian Investment Strategies - The Next Generation"

• Jim O'Shaughnessy -- Growth/Value Investor - based on "What Works on Wall Street"

• Motley Fool -- Small-Cap Growth Investor - based on "The Motley Fool Investment Guide"

• John Neff -- Low PE Investor - based on "John Neff on Investing"

• Joseph Piotroski -- Book/Market Investor - based on "Value Investing: The Use of Historical Financial Statement Information to Separate Winners From Losers"

Kirk:  Why do you think it is important to follow and perhaps implement the strategy of more than one guru?

John Reese:  By diversifying among multiple strategies investors are able to reduce strategy-specific risk. One thing I've found is that all of the models will go in and out of favor. Investors who follow one approach may not have the resolve to stick with that approach during periods when it stops working. However, implementing a consensus-based approach, like I do with some of the portfolios on Validea and in my managed account portfolios, helps protect investors if one specific strategy falls out of favor and allows investors to stick to a strategy to get the best long-term return.

Kirk:  Have there been any gurus you've attempted to develop a model portfolio for but later proved through your research and backtesting that their strategy simply didn't work?

John Reese:  No, I have kept all the portfolios that I have implemented. The fact that I only select models with pre-existing long-term records is likely the reason for that.

Kirk:  As you've mentioned, even the gurus you've chosen to develop model portfolios for will have periods of relative outperformance and underperformance. What does your tracking performance and research show regarding this? Have you discovered that some gurus tend to outperform and underperform in different types of markets? Why do you think that may be?

John Reese:  You are absolutely right and this is an extremely important point. I have yet to see a strategy that outperforms every year, much less every month or week. In fact, almost every model I follow has experienced at least one 3-year period where it underperformed. The market can be very fickle and it can like different types of stocks at different times, and as a result, nothing works all the time.

My strategies each use very unique criteria. Most are value based, but some migrate to small-caps and some migrate to larger stocks. Some are very deep value, while others have more of a growth component. This leads to underperformance in very different types of market periods for each strategy. As an example, people ask me all the time which strategies do best in bear markets. Well, the answer to that is not what they expect. The answer is that it is different for different bear markets. In the bear market that started in 2000, value outperformed by a wide margin and many of my models produced positive returns in testing, despite the market decline. In 2008, the selling was indiscriminate and it didn't matter how you selected stocks - nothing worked.

Kirk:  So, which strategy did the best in 2008 and why?

John Reese:  My best performing strategy in 2008 by a pretty wide margin was the one based on Ben Graham. It was down 14.1% while the market was down 38.5% (both those figures do not include dividends). The strategy did well because it had a great first half of the year, which allowed it a large cushion prior to the declines in October and November. It also was up over 10% in December to close out the year. Why it held up better than other deep value strategies is something that is difficult to explain. It is probably the deepest value strategy I follow and so the companies selected tend to have what Graham called a "margin of safety" over fair value, but that doesn't make it immune to declines so I don't want people to think that the approach is immune to bear market volatility. I have yet to see a strategy that is 100% long stocks that is immune to volatility and underperformance.

Part of what helped the Graham model was that it uses some very stringent balance sheet criteria -- for example, it requires a firm to have more net current assets than long-term debt, and it requires the firm to have a high current ratio (which measures liquidity). It thus finds some of the most financially sound stocks in the market, and during the financial crisis, those types of conservatively financed firms were what investors tended to buy, or at least hold on to.

Kirk:  Did the market decline in 2007 and 2008 make you question the effectiveness of the strategies?

John Reese:  For me, it did not, but I can understand why it made many other people do so. It is incredibly difficult to sit there and watch those kind of losses and it is very easy after the fact to look at the guys who predicted it beforehand and say that you should have listened to them. But that is a very dangerous game to play, because timing the market is a losing proposition in my opinion. It is very easy to pile on the bandwagon against a particular approach or the market in general when things aren't working, but the reality is that predicting that type of thing in advance is incredibly difficult and the people who get it right one time are not likely to get it right the next time around. So to me, it is better for your average investor to stay the course during times like that than to try to figure out when to get out and when to get back in. And the strong rebound we have seen in 2009 backs that up. Many investors who got out during or after the bear market have missed big gains following it.

Having said all of that, however, I do think there is a place for market timing in specific cases. I tested the Validea Capital Market Rotation portfolio over a 40-year period and it did perform well over time. The reason that some of my clients use that model is not because I expect it to outperform a long-only approach - I don't expect that. The reason is that for some people, making the ride along the way smoother is more important than having the best long-term returns. So some clients will give up some long-term returns to sleep better at night, but I think the key if you are going to do that is to do it using a disciplined system, and don't just do it based on your own whims. I developed a market timing model to do exactly that, although as I said, I think staying fully invested is still the way to go for most long-term investors.

Kirk:  What strategy is performing best so far this year (2009)?

John Reese:  The model I developed based on "The Little Book that Beats the Market" by Joel Greenblatt is up +55.8% so far this year (through 11/10/09) which makes it my #1 model by a fairly large margin.

Kirk:  Why do you think that strategy has been so effective in today's market?

John Reese:  The Greenblatt model really honed in on some incredible values that were created during the bear market and has had some huge gaining positions this year as a result. I like that strategy a lot because of its simplicity. It gets to the heart of the two things that really matter when evaluating a stock: profits and valuation. It looks at valuation via the earnings yield (which is similar to the inverse of the PE ratio) and looks at profitability via return on capital, ranking each stock in both categories. It then combines the two rankings and takes the top 10 stocks based on that combined ranking score. The indiscriminate selling of 08 and early 09 created some readings on that combined score that I hadn't seen in a long time, and the model honed in on those stocks and has had a huge 2009 as a result.

Kirk:  Over the entire period of tracking these guru screens, which has been the most consistent and best performer overall?

John Reese:  The strategy based on Ben Graham is the best overall performer by a fairly wide margin. It is up 16.7% annually since I began tracking this model in 2003, vs. 1.4% for the S&P 500. Of the 7 calendar years I have tracked it, it has underperformed in only one (2007). It has always amazed me how well this approach works since it was created so long ago and in a very different world from the one we live in now. But by looking for deeply discounted stocks and ensuring that a company's balance sheet is solid, it is able to avoid large losses for the most part and is able to find some very big winners over time.

Kirk:  Has there been a guru-strategy that has surprised you the most in terms of its performance either good or bad?

John Reese:  Yes, an interesting one is the one that was outlined in the Motley Fool Investment guide by the Gardner brothers. I am often asked why I included that model (Small-Cap Growth Investor) on Validea.com because they are not considered the Wall Street gurus that many of the other people I follow are, but their strategy works incredibly well. It is the second-best performer of all I follow behind Graham, and is the only one that has not had one underperforming year in the 7 calendar years I have tracked. It is also surprising to me because it is primarily a growth strategy and I have found that there are very few growth strategies with that kind of consistent record.

Kirk:  I'd be willing to guess that a number of subscribers to Validea will frequently visit your website, spend a few moments to find out which screening approaches have been outperforming the most recently, and then look at (and perhaps buy) the stocks recommended by that approach. In your opinion, is that an effective way to use your website?

John Reese:  When a subscribers ask me how to best use the portfolios on the web site I tell them that they need to look at each model to find the one that makes the most sense them. I try to discourage them from looking at performance only.

They should try and take the time to understand the gurus, the types of stock these models select and the pluses and minuses of each strategy. For example, have the returns been consistent year over year or are the returns highly volatile? Does the model tend to select large caps, small caps, value stocks or growth stocks? These are some of the important questions subscribers should ask.

Once they commit to a guru, or consensus portfolio, my best advice is that they need to stick to the approach in order to get the most benefit from it. They can't jump from strategy to strategy based on what's performing well recently. That's a losing game and in most cases will detract from returns. The other thing I try to emphasize is buying all of the stocks in the portfolio - 10 or 20 names - and not cherry picking only a few from the list. By buying all of the stocks you are statistically putting the odds in your favor that 50-60% of the stocks will be winners over time (most of my models have long-term accuracy rates in that range) and thus limiting stock-specific risk. As soon as an investor starts subjectively picking the ones they like best, they are investing outside of the disciplined model and often times that hurts performance.

Kirk:  How would you recommend someone best utilize the portfolios and tools provided at Validea?

John Reese:  There are three different features on Validea I'll highlight.

First, are the guru and consensus portfolios, which we've been discussing. My best recommendation here is that investors find the portfolio that best fits their needs, and then follow that portfolio with the utmost discipline and consistency. I offer portfolios that are always rebalanced on a set timetable (you can choose monthly, quarterly or annually) and offer 10- and 20-stock models for each approach. I've tried to make each rebalancing as simple as possible so that investors can follow a portfolio without spending hours and hours of time on it.

For investors who are looking for validation of investment ideas, I think the site's Guru Analysis tool offers a unique approach to analyzing stocks. On the site, you can get a detailed analysis of over 6,000 securities using the guru strategies I run. The Guru Analysis tools tells you what variables the stocks passes or fails on each individual strategy, and generates a final score for each approach. This feature gives you insight as to a company's/stock's financial and valuation strengths and weaknesses.

For those that are looking for specific investment ideas, I think the Guru Stock Screener or Advanced Guru Screener is a nice option. Using this tool, you can screen for stocks that pass one specific guru strategy or mix and match approaches to find stocks that meet multiple guru models. For investors who are looking for just a few investment ideas, this is powerful screening feature that can help narrow down the list of names to look into further.

Kirk:  Are there any tools at your website that you think really are powerful in helping investors to succeed?

John Reese:  I think the best tools that help investors most are the model portfolios. With those, I have taken the 12 strategies I track and made them into an easy-to-follow investing system, which takes a lot of guesswork out of the process.

Kirk:  Within my own stock screening, I have often found that the stocks that show up most frequently among all of the different screens I use tend to outperform others. Has this been your own experience as well?

John Reese:  Yes, I have found that as well. What I have found works best in combining strategies is to take into account how many strategies agree on a particular stock, as you said, but also to take into account the long-term performance of the strategies that do agree. So for example, if a stock meets the tests of three strategies with great historical performance, that stock likely does better than a stock that meets the tests of three strategies with lesser performance. That is the concept behind my Validea Hot List portfolio. Its scoring system uses both of those aspects (number of strategies interested and the historical success of those strategies) to combine all my models into one portfolio. That portfolio has done very well using that approach, up +14.2% annually since its inception in 2003 vs. 1.4% for the S&P 500 over the same period.

Kirk:  Do you ever track the stocks that are being dropped and/or abandoned from the model portfolios?

John Reese:  I do not track stocks that are removed. I have done some testing as to whether my models work for shorting the stocks with the lowest scores, but I have found that by and large they do not.

Kirk:  While your website is very much focused on stocks, you do offer some sector-focused analysis through you Top Industries Report. This apparently shows which industries have the largest number of stocks passing your guru strategies. Have you found this a helpful leading indicator of sectors to outperform in the future?

John Reese:  I haven't done a lot of research on sectors because I am a big believer in bottom-up investing, so I pick the best stocks and let the sectors fall where they may. I have found, however that when my models concentrate heavily in one particular sector, that sector does tend to outperform over time. But the effect is not immediate and the timing can vary, since the factors leading that sector to be out of favor (and thus presenting good buying opportunities) tend to take a while to correct themselves.

Kirk:  Have you ever tried to incorporate the use of ETFs in your work?

John Reese:  My system is geared to select individual stocks, so I have not looked at applying it to ETFs.

Kirk:  Some may argue that any attempt to boil down a guru's strategy to a basic 10- to 20-stock portfolio (rebalanced monthly, quarterly, or yearly) is fraught with issues. I would guess that not many of the gurus you've based screens upon (like Peter Lynch or Ken Fisher) believe that someone could invest just like they do simply by running a stock screen based on a few parameters. How would you respond to address this critique?

John Reese:  I think you are right that you can't invest like someone like Fisher or Lynch just using fundamental data, since they also use qualitative factors that can't be computerized. I am not advocating trying to invest exactly like them, though. What I am saying is that the quantitative parts of the strategies that they have outlined in their books produce long-term market outperformance in their own rights. So my goal is to use those principles to produce long-term market outperformance, rather than trying to mirror those investors' actual holdings.

Kirk:  Some of the gurus you track are still alive and managing money professionally. Have you taken the time to look at how the model portfolios you share compare and contrast with their real-portfolios? If so, have you found wide divergences or lots of examples of similarity between your model portfolios and those of the gurus?

John Reese:  I have not done in-depth studies on this, but I do look at this periodically, especially with respect to Warren Buffett. In his case, I would say the level of agreement is mixed. In some cases, we have identified stocks that meet his tests and written articles about them, and then Berkshire did end up taking positions in them. But in other cases, Buffett has strayed from the fundamental principles that he has used in the past. A good example of that was his recent acquisition of Burlington Northern. That company does not meet most of the tests of my Buffett quant model, but because he feels the company is a good play for a general rebound in the economy, he made the decision to acquire it. As I talked about in the previous question, in general, my strategies are not designed to try to match the stocks that the gurus own. I have found that their quantitative principles work very well as standalone strategies, and even if they disagree with the gurus in terms of actual holdings, they exhibit very strong long-term performance in their own right.

Kirk:  In a serious attempt to follow and track the so-called "smart money," in recent times new websites like alphaCLONE have popped up providing investors will the ability to create clones of portfolios based on real-transactions by professional money managers. What do you think of this approach in comparison to your own? Obviously the big difference here is that your model portfolios rely on published strategy theory than actual transactions for portfolio creation.

John Reese:  Clone portfolios, like those that alphaCLONE produces, can do well over time. I recall reading a study in Bloomberg last year that looked at Buffett holdings and calculated the return an investor would have realized if they had purchased those same stocks ninety days after Berkshire's initial purchase. I believe the return on cloning Buffett would have compounded at over 20% for a long period of time. Of course, that's Buffett, but alphaCLONE, like us, is piggybacking off of successful investors, albeit differently than Validea's quantitative approach. The one thing that will be interesting to see is if individual investors are willing to actually invest money in what appears to be old, or stale, ideas even if the performance results are good. That's a psychological hurdle sites like alphaCLONE may face.

Kirk:  Beyond alphaCLONE, websites like Covestor and kaChing are now allowing investors to follow their favorite gurus in real-time. In your view, why is your model portfolio screening approach better and more effective than just following the investors and traders in this way?

John Reese:  Covestor and KaChing are interesting concepts, and both of these firms seem to have strong momentum and have gotten lots media exposure. I'm not one to say whether my approach is better than theirs, but I do think what could be a challenge with these Web 2.0 approaches is it's not totally clear there would be discipline and consistency among the underlying managers. Since Covestor and KaChing act as an intermediary between the potential manager and investor, I think the core investment strategy takes a back seat to the performance, and that could be problematic -- particularly when a good strategy stops working in the short term.

Kirk:  Have you considered teaming up with websites like Folio Investing to offer your portfolios as trading vehicles? Why or why not?

John Reese:  Currently, we use FOLIOfn for our private account business, but we do not offer the models on Validea in any autotrade programs. From our perspective, we have a research business and an advisory business and we keep them completely separate, so we restrict direct management using our models to investors who become clients of Validea Capital.

Kirk:  Many readers of this Q&A will have used stock screening to some degree in the past. I'm sure they would like to know a little bit about what are some of the most common variable/metrics used in these guru screens you track. Can you offer some guidance in this area?

John Reese:  The most common metric among all my gurus, surprisingly, is debt-to-equity. I would have expected it to be a valuation ratio such as P/E or something like that, but many of the strategies I follow prefer to buy companies with no or minimal debt. After that, there is not really another variable that is used by a majority of my models. Almost all of them have some sort of valuation criteria, but they all tend to use different variables. I also have several that like to see insider buying or high insider ownership.

Kirk:  Why do you think those variables tend to provide relative outperformance when screening for investment opportunities?

John Reese:  I think debt-to-equity is a good indicator because firms with low debt tend to have more predictable earnings and less risk over time. During difficult economic times, like what we are going through now, firms that have high debt loads face significantly tougher challenges than those with little or no debt, and the gurus I follow recognized that and shied away from companies with excessive debt for that reason.

Kirk:  Explain to me how one of your guru-based portfolios is created. For example, let's take the Graham strategy, which is your best performer since 2003. How is the portfolio constructed?

John Reese:  There is a lot of technology used in the creation of the models, but let me give you an overview for how each portfolio is created from start to finish. Each night we get a data feed from our data provider with the latest fundamental information. Once we receive the data, we import it into our system and run a number of internal processes that checks for errors. Once the data is loaded, we then run thousands of internal calculations and algorithms that look at each stock in our database and run it against each and every guru criteria. The outcome of that process results in all stocks being scored on the basis of 0% to 100%. This process takes place on a daily basis. In constructing the guru portfolios, which we do on a monthly, quarterly or annual basis, we then select the top-rated stocks to be added to the portfolio. So let's say for the Graham strategy, there are five stocks that get 100% and 5 that score 90%, the portfolio will hold those ten stocks. Then, on the next rebalancing date, if one or more stocks in the portfolio have fallen in score, and other stocks that weren't in the portfolio have surpassed them, the lower scoring holdings will be removed and replaced by better scoring stocks. We do require certain liquidity requirements to be met in order for stocks to be included in the portfolios, and we have a tiebreaking method in the case that stocks obtain the same score.

Kirk:  Within all of the model portfolios you've created, which is your personal favorite and why?

John Reese:  I don't have a favorite. Each one is different, whether it be analyzing a stock/company using Lynch's famous PEG ratio, Buffett's long-term look at ROE and expected return calculations, Piotroski's book-to-market ratio, Dreman's deep contrarian approach, Neff's focus on dividends or Zweig's measure of earning persistence. They all offer a unique twist on investing and each one has aspects that appeal to me.

Kirk:  Are you working on or planning for the addition of new model portfolios beyond what you've shared so far?

John Reese:  I am always on the lookout for new strategies, but at the current time there are no plans to add to the gurus I've mentioned above. The types of strategies that I look for are few and far between, so I don't add new strategies to the site often. The last time I did it was the Greenblatt model in 2006.

Kirk:  Is there any criteria your experience has shown that should be avoided when creating model portfolios and stock screening?

John Reese:  There is not one specific criterion that all the gurus I follow specifically avoid. But I would say that most tend to avoid short-term criteria in favor of looking at things over a longer period of time. They also primarily tend to use fundamental analysis, although a few do have some technical criteria.

Kirk:  You provide access to both growth and value screening approaches. How should an investor decide which one is more appropriate and useful?

John Reese:  I think in general, value is a better bet for most investors. Growth can be tantalizing at times, but at some point, valuation has to come into the picture. In the real world, however, the lines are much more gray. All the growth models I follow have some aspects of value in them, and most of my value models have some aspects of growth. In my mind, there is no reason to pigeon hole strategies into one camp or another because for value to work, a company has to eventually grow, and for a growth strategy to work in the long run, valuation will eventually have to come into the picture.

Kirk:  Do you believe that screens should act as a starting point or do you follow the screens religiously without filtering ideas further?

John Reese:  There is a subtle but important difference between screens and screen based portfolios. My experience with screens is that they should probably act as a starting point. For example, if you run a screen on Validea looking at all stocks that get 90%+ from our Peter Lynch strategy, you are going to be looking at an unmanageable list of names and buying all of those stocks is not reasonable or a good idea. However, the portfolios we track, which have 10 or 20 of the highest scoring stocks based on a particular strategy, can be used as the final list. For investors following a screen-based portfolio, my advice is that they stick to buying all stocks in the portfolio. By following this disciplined approach they remove the key biases and emotions that often times hurt investors, and statistically put the odds in their favor that the strategy can work for them over time.

Kirk:  Speaking of filtering down ideas, the model portfolios you share include a sizing parameter - for a 10 stock portfolio or a 20 stock portfolio. If the screen produces far more candidates, how does your system filter it down to only 10 or 20 stocks? I know those who create and track their own screens will be very interested in how you narrow down the target research candidates in a consistent and effective manner without falling trap to over-optimization problems that elevate risk, position concentration, and portfolio volatility.

John Reese:  For each of my models, I calculate a score between 0 and 100 for each stock that shows how closely the stock meets the criteria of that model. That score is what I use as my first criteria to come up with the 10- and 20-stock models. So the highest 10 or 20 scoring stocks are added to the model portfolios. In many cases where a small number of stocks score highly according to a particular model, that is enough, but for others where there are large numbers of stocks that meet 100% of the criteria, I use my other models as the secondary sort. So if I have 100 stocks that score the same for a particular model, I sort those based on the total number of all my models that each passes and the top 10 or 20 of those end up being added to the model portfolio.

As far as how I picked 10 and 20 stocks as the number for my portfolios goes, it was done by looking at the diversification curve and finding numbers of stocks that added significant diversification benefits, but were still manageable for individual investors to keep track of.

Kirk:  If one of your guru model portfolios highly ranked more stocks from a specific sector, how would you deal with that issue? Does portfolio weighting and correlations play any role in the creation of and maintenance of your model portfolios?

John Reese:  I don't enforce industry concentration limits on the Validea.com portfolios. Since Validea.com is for self-directed investors, I let investors make their own choices as to how many stocks is too many in a particular industry or sector. In my testing, I have found that not using industry concentration limits works best, and although it does sometimes lead to concentrations in particular industries, they are usually short-lived. My monthly rebalancing approach allows the weighting to be adjusted when the scores of individual stocks in that industry are no longer among the top stocks.

Kirk:  I notice in your advanced guru screener, you allow subscribers to add in their own filters using fundamental data. Can you provide a few examples of filters you've found particularly useful in this regard and why those parameters tend to be effective?

John Reese:  On Validea we have a number of value-oriented models, including ones based on Buffett, Graham, Neff, Piotroski and others. One of the things I like to look at is combining these value approaches with some growth or momentum based metrics to see what value stocks are on the move or which ones have good historical growth rates but are selling at a discount. You can add in variables like relative strength or a 5-year average growth rate to narrow down the list. The other thing we do a lot is filter down ideas in specific sectors or industries. For example, if you wanted to see which stocks in the Technology sector pass both the Fisher and Lynch strategies you can do so using this tool.

I tend to use the Guru Screeners as a way to find investing ideas that I write about in various media outlets, so that I can talk about my strategies in an easy-to-understand, cohesive context -- "Five Guru-Strategy-Approved Small-Caps" could be one example. But while the Guru Screener is a good way to come up with ideas if you are interested in a particular type of stock or area of the market, it's important to note that when it comes to my model portfolio system, I never tinker with or add variables -- I always stick with the original guru models. As a result of this, it's difficult for me to comment on what additional parameters tend to be most effective. What I can tell you is the Guru Screeners are popular among more sophisticated users of Validea who are looking to narrow down the list of stocks based on other metrics they think are important.

Kirk:  As you mentioned previously, there is a strong bias toward using fundamental rather than technical criteria within the strategies. Is it your view that technical analysis is not useful? Why or why not?

John Reese:  There actually are a few strategies that use some technical criteria, primarily relative strength, but you are correct that by and large most of my strategies are fundamentally driven. I do think that fundamental analysis is a better way to select stocks because it does a better job at getting at what drives stocks over long periods of time, but as a general rule, I will use any strategy that works. I have found that most of the strategies that meet that test use fundamental analysis.

Kirk:  There are a number of proprietary stock ranking systems available online for purchase (Value Line, Zacks, Market Grader, VectorVest, IBD, etc.) These services essentially offer a grade or rating based on their own fundamental and technical filtering to "help" investors figure out the best stocks. What has been your personal experience in using these ranking systems for screening purposes and have you found them at all useful?

John Reese:  In general, I find them not helpful in picking individual stocks. Any one stock highly rated by these systems is too random for an investor to be confident of outperformance or even breaking even. However, a couple of these systems have been independently shown by the Hulbert Financial Digest to have value when an investor picks and maintains a portfolio of 10 to 100 of the highly ranked stocks from one system, and adheres to the same strategy for several years. Value Line is such a strategy. Zacks is such a strategy if an investor can tolerate its volatility (large drops) and still adhere to the strategy for the long term. The other ones you mentioned don't have an independently verifiable track record that I am aware of for beating the market over a long period of time, and certainly not on a risk-adjusted basis. This might surprise some of your readers given their popularity and given the very clear reasoning those systems present for highly ranking a stock.

Kirk:  Have you ever thought about creating a "guru sell portfolio" - i.e. a model portfolio of stocks that the gurus dislike the most for potential short sell opportunities? What has been your own experience in screening for future losers?

John Reese:  I have found that none of the strategies I follow are very effective for selecting short sale candidates. One of the reason I think this is true is that the models tend to pass very small numbers of stocks and so you are left with a huge number of stocks that don't pass and many of those get scores that are either low or are close to 0. Finding a way to find short sale candidates out of those large groups is something that I haven't been able to figure out. Also, since the market goes up more than it goes down, it is nearly impossible to find shorting strategies that show positive results over the long term, and since that is my criteria for selecting models, it makes it difficult to use models that short.

Kirk:  I notice that you offer model portfolios that are rebalanced monthly, quarterly or annually. Do you have any insight you can share on the risk and return characteristics of the various rebalancing approaches and how does one determine which rebalancing method is best?

John Reese:  There are a lot of factors that weigh in that decision and many of them are factors that are specific to each individual, which is why I decided to show all three rebalancing periods on Validea.com and let users decide for themselves. From a return perspective, the monthly approach has worked best for almost all my models, but for users in high tax brackets in taxable accounts, annual can make more sense since it results in a higher after-tax return. Also, the amount of time that a user wants to put into it can also play a role. Some users prefer more of a "set it and forget it" approach and others like to be more active. So I have tried to put all the rebalancing periods out there in order to let users weigh all the factors and decide for themselves.

Kirk:  How do you monitor and deal with high rates of model portfolio turnover and churn? Are some model portfolios you share more susceptive to churn than others and, if so, why do you think that may be?

John Reese:  On Validea.com, I deal with churn by offering the varying rebalancing periods. For investors looking for a lower turnover approach, I offer the annual models and for those comfortable with higher turnover, the monthly returns in most cases provide the excess return to justify their high turnover. In general, my growth- and momentum-based models will have higher churn because they include more variables that change with the day to day fluctuations in the market. All the portfolios, when rebalanced monthly, will have high turnover, though, because I remove any stocks that fall outside of the top 10 or 20 on each rebalancing date and replace them with the newest high scoring stocks. By its nature, that type of process will lead to high turnover, but it also leads to stronger returns, which makes me comfortable with it.

For Validea Capital, where we look at each person's individual situation and develop portfolios for their personal needs, we manage turnover using a tax-efficient system we developed. It looks at a variety of factors, including a stock's current score on the strategy we are using for that portfolio, its holding period, whether we have a gain or loss and the magnitude of that gain or loss, as well as a few other factors to decide when to sell. This results in significantly lower turnover than the monthly portfolios on Validea.com.

Kirk:  How do you track the performance of your model portfolio and how does portfolio churn (transaction costs, taxes, etc.) compute in your tracking performance of those portfolios?

John Reese:  On Validea.com, we track our returns based on taking equal positions in each stock within our portfolios as of the close price on each rebalancing date. We issue our changes every 4th Friday at 11AM and do not lock in our start prices until the close. We do this to ensure that if our changes move stocks in any way on the day of the change, we do not incorporate that effect into our returns. The returns on Vallidea.com are not inclusive of dividends, transaction costs or taxes. For transaction costs, with the advent of brokers like FolioFN that allow users to follow systems like this extremely cheaply, they can no longer be a significant factor in returns, which is why I exclude them. For taxes, the site is geared toward many people, and because some people have taxable accounts and some don't, and because people have varying tax rates, I didn't think it was appropriate to try to factor in taxes. Obviously, in taxable accounts and for people with higher tax rates, the annual portfolios can be a more attractive option than the monthly ones for some models.

Kirk:  I know that it's one thing to run the screens but I have to imagine it's another thing manage real investment portfolios utilizing these strategies. If we can, please share your thoughts about the transition between seeing a stock that shows up on one of your model portfolios and then what you do to figure out whether it is an actionable idea and what steps you take to then determine whether to actually own the stock?

John Reese:  Whether it be on the models of Validea.com, or in Validea Capital where I manage actual money, I treat all the stocks that show up in the models as actionable ideas. I believe that human input makes these models worse, not better, and so I adhere to them completely and strictly. The only exception would be if a company that meets my tests is involved in some sort of accounting scandal or something like that. In that case, I would override the system and replace that stock with the next highest scoring one. That has only happened twice that I can recall in the 6 years since I launched Validea.com, though. These systems work so well because they work on average over groups of stocks. They will obviously be wrong on individual stocks at times, but the impact of that is minimized through diversification. I have found that it is not better to try to filter the selections that the model portfolios pick.

Kirk:  How do you determine when it is time to sell the investment? What sell criteria do you use and why would you exit a position?

John Reese:  For Validea.com, I sell a position when it is no longer in the top 10 or 20 stocks for that model on one of my scheduled rebalancing dates. I then replace it with a new stock that is in the top 10 or 20 based on that model's criteria. This ensures that I always have the top-scoring stocks in my portfolios.

For Validea Capital, my tax system looks at the other factors I discussed before and couples them with the fundamental score of the stock to decide when to sell. What I tried to do for clients is to create a sell system that looks at selling the same way a person would, but without the emotion that often plagues people. So this system looks at things like holding period and gain and loss to determine when to sell. By doing this, I am able to make the majority of the gains we take long-term gains, which helps to boost after-tax returns.

I think in general, the key to selling is discipline, just like it is for buying. People tend to let their emotions get the best of them even more so when it comes time to sell and it really hurts their returns in my opinion. So for me, the most important advice I can give regarding selling is to periodically review your portfolio for candidates to sell and to have a system and stick with it.

Kirk:  Effective risk management requires more than a sell strategy. What other methods do you employ (position sizing, asset allocation, etc.) do you employ within your own portfolio to produce more consistent returns?

John Reese:  For Validea.com we take equal positions in all holdings to prevent overexposure to one security. We do not impose sector limitations on Validea.com and allow users to make that decision for themselves.

For Validea Capital, we also take equal positions and we impose sector limitations to prevent over exposure to any individual sector. We also use stop losses, but they are very loose stop losses because my research has indicated that although tight stops can make people feel better about not taking losses, they don't enhance returns. Validea Capital also offers portfolios with a mix of stocks and bonds, as well as the Market Rotation model I discussed earlier, which will go to cash when the market breaks down technically.

Kirk:  I noticed that you have two rotational portfolios at your professional money management website but few of the gurus you follow promote market timing systems. Can you explain that difference a little more and your reasoning for offering that type of investment strategy?

John Reese:  You are correct that most of the gurus we emulate discouraged investors from market timing. The problem with market timing, as most people know, is that the vast majority of investors lack a disciplined approach to moving in and out of stocks and as a result long-term performance of market timers, as a group, tends to underperform that of the buy-and-hold investor. The gurus we follow understood this problem and tried to help investors by explaining how moving in and out of stocks typically detracted from long-term results. As we discussed earlier, I think buy-and-hold is the best way to go for most investors. But for some people, giving up some long-term return in exchange for more downside protection is a tradeoff they are willing to make. That is what my rotational models are for.

I think there's also the question of reliable timing systems and what indicators make up a timing approach. The one thing I will say here is that no timing system is perfect, but if you can find one that protects you from the major downturns, that is really what you are looking for.

Our main overarching goal with our rotational portfolios is to offer clients an approach that will participate in the market most of the time but have triggers that allow for loss protection in bear markets. One of the things we've realized is that many investors may lack the convection to stick with a strategy, even if it's a great strategy, through the difficult periods, particularly in bear markets. As a result they make the mistake of exiting a good strategy at the very worst time. Because our rotational portfolios have the ability to move to a cash position to help protect capital, it gives clients who are invested in those portfolios the confidence they need to stick with our approach. Now the flip side of this is that the rotational portfolios won't be in the market at the start of a bull market. For example, our rotational portfolios didn't get back into the market until the last week of March (the market bottomed on March 9th), but the lag on getting in at the bottom is really the "cost of the insurance", as we like to say.

Kirk:  Do you think strategies devoted to market-timing are more effective than buy-and-hold?

John Reese:  I think over most five to ten year periods in the market, buy-and-hold will outperform market timing. But there will be periods, like the last ten years, where market timing will have outperformed buy-and-hold. A lot depends on if the market is under or overvalued when you get in, the success rate of the timing system and the underlying investment strategy you use when in the market.

But I think the question investors need to ask themselves is can they stick with a buy-and-hold approach through an entire market cycle (or multiple cycles). A lot of investors can't, and coming off of the period we just went through I think that investors are very sensitive to market risk and volatility. So they will give up some long-term returns in exchange for some protection.

Kirk:  For someone with limited time to learn the ins and outs of the market and who is very part-time, do you recommend using stock screens as a basis of a strategy or alternatively just use broad market-matching index funds and ETFs?

John Reese:  For beginning investors with limited time, I would say index funds and low-cost ETFs are best if they are looking to manage their own portfolio.

Kirk:  Volatility has been a big problem for investors of late. Do you have any recommendations based on your experience that have been helpful to manage and cope with all of this volatility?

John Reese:  My best advice is to try to ignore it if you are a long-term investor. That may sound like the opposite advice that most people give, but the reality is that most of the moves that individual investors make in response to volatility end up being the wrong ones. Emotion leads people to sell during times of panic and to buy during times of euphoria and both of those approaches don't work in the long-term. So my best advice to cope with volatility, if you are invested in a system that you believe in over the long-term, is to ignore it and not to try to respond to it. I understand that doing that can be extremely difficult, but I think it leads to the best returns.

Kirk:  In addition to volatility, there has also been high asset correlation (i.e. all sectors have moved relatively in agreement with each other during both the major rallies and corrections). Any thoughts on why this may be and do you have any methods that help investors properly diversify their holdings?

John Reese:  During times of extreme panic or euphoria, this does tend to happen, but it can only last for so long before valuation and earnings become important again. My advice is to stay the course through it and that eventually fundamentals will matter again. In the long-term this correlation between everything always breaks down and the benefits of stock selection return.

Kirk:  We all know that individual investors make mistakes when it comes to investing as you've mentioned. Can you share with us some of the most commons shortfalls you've found in either yourself or your clients that can help us understand what those shortfalls might be and how to overcome them?

John Reese:  Hindsight bias, recency bias, loss aversion, anchoring, conviction bias and overconfidence. Each one of these concepts would require detailed explanation and they are just a few of the biases that influence all of us when making investment decisions. The important thing investors need to know is that whether you think it or not, these emotions exist in all of us and impact our decisions. To overcome them, the goal is to try and develop a consistent framework that keeps the decision making as objective and measured as possible.

One of the key advantages of Validea's system is that because it is computerized, it is free of all of these biases and emotions. The systematic strategies and fundamental data is what drives the investment decisions, not the emotions in my head. The computers never have a bad day, they don't worry about the last decision or anchor on past events, and they are not overconfident in the decisions or worried about a particular position losing money. I think this is one of the reasons for our success.

There was an excellent article on WSJ.com "How To Ignore the Yes-Man In Your Head" by Jason Zweig which recently highlighted some of these behavioral shortfalls we have as investors.

Kirk:  You've been in the online research space since the late 90s. How has the landscape changed over the years?

John Reese:  The number of players in the space has gone up dramatically. This has been both positive and negative. It has been positive in the sense that some great new ideas that really help investors have come to fruition. It is negative in that it can be much more difficult to try to distinguish quality research from research that is more detrimental than good. There are a lot more ads promoting things like 50% performance in a week and other misleading claims, and I think those types of ads lead investors in the wrong direction.

Kirk:  In the coming years, what trends do you see ahead for online research, stock screening, etc. that you think offer the most potential to help and hurt investors?

John Reese:  One of the trends you're going to see emerge is more screening products applied to international markets. I think investors will continue to seek out research on non-US firms. Also, with the popularity and demand for ETFs, I think more ETF screens may begin to emerge. I'm not talking about technical ETF screens but techniques that may look at the underlying holdings of ETFs and analyze the investment prospects based on the fundamentals.

Kirk:  What are some important things that you have learned so far that would have surprised you initially as a new investor and/or someone who doesn't use quant-focused strategies?

John Reese:  I think the biggest surprise to me is that outperforming the market is both very difficult and not difficult at all, at the same time. Or, as Warren Buffett has said, it's hard, but it doesn't have to be complicated. What I mean by that is that there are strategies out there that outperform consistently over time and, as I hope I have shown with Validea.com, they can be very easy to follow procedurally. My models on Validea.com only trade one day a month and although they can be complex behind the scenes, they are very simple for users to follow. And despite that, most users can't do it.

The reason is that they give in to their emotions and when a strategy stops working -- and all of them do at times -- they give up and move on to something that has worked recently. This kills them in terms of long-term returns. It is the same phenomenon that people talk about with the difference between fund returns and investor returns with mutual funds. Almost across the board, the investor returns of mutual funds are below the actual returns because investors get in and out at the wrong times and chase hot recent performance. Having the discipline to stay the course is something that sounds easy on paper, but is extremely difficult in practice. That is one of the reasons that I started managing money, because as a money manager I can help to prevent investors from falling into this trap.

Kirk:  In addition to your own website, what stock screening tools do you use and why?

John Reese:  This may surprise you, but I don't use any other screening tools. If I see an approach that I think has long-term merit, I will implement it into my own system rather than trying to follow it somewhere else. Also, the vast amounts of data I have access to in our own internal systems allows me to run pretty much any screen I want to, so I don't require outside tools.

Kirk:  Performance tracking is always a challenging aspect for most investors when evaluating model portfolios and strategies. Any recommendations on how to do this on your own for the average investor?

John Reese:  All of the portfolios on Validea are tracked and maintained using internally built systems. I've seen a couple of people use Google Spreadsheets, which has pluses and minuses, and most of the major finance sites have decent portfolio trackers. I think Microsoft Excel has some nice portfolio add-ins as well. But since we've created our systems internally I don't have much experience with other cost-effective portfolio tracking systems for individuals.

Kirk:  A common element I find in all successful investors and traders is that they are always working on expanding their knowledge and improving their strategies. What have you been working on lately in this regard?

John Reese:  I tend to always be working on a lot of ideas I have as to how I can enhance returns or lower risk. Part of being a quant manager is constantly testing things. Most of the time, when I test things, I find that the thing I am testing ends up not enhancing returns, but it is worth the constant testing when you find the rare thing that does.

A lot of my testing work recently related to market timing. I am generally not a believer in it as we talked about before, but I wanted to find a disciplined system that could be used for those investors that want an additional degree of protection, even if they give up some long-term return to get it. I think I found such a system with the technical system I use for my market timing portfolio, but it took a lot of work to get there.

Another thing I am constantly doing is reading new investment books and academic research papers to try to come up with new strategies. I rarely find strategies that meet my criteria of having solid long-term track records, but when I do, it can be well worth it. A good example of this has been the strategy based on The Little Book that Beats the Market by Joel Greenblatt. That strategy had been tested extensively and had a great long-term record, so I began following it right around the beginning of 2006. It has more than lived up to my expectations and has done well in all kinds of different market environments. The biggest benefit I did not see in advance is that portfolio is one of the least correlated with my other models, and so it offers great diversification benefits in my combined portfolios.

Kirk:  Thinking back at your career, what were some key lessons that had the most positive influence on you?

John Reese:  I didn't mention it before, but I also undertook a massive research project studying the outcomes of the stock picks and pans of 50 different periodicals, business TV shows and online sources over several years. I was trying to identify which experts or columns I should follow to have consistently high performance. The key lesson I learned was that no matter how well reasoned or respected the source or recommendation was, it was totally random what the performance of the recommendation would be 1 week later, 2 weeks later, 1 month, 3 months, 6 months and 1 year later. I could not identify a single person, column or source to follow that gave consistent outperformance over those periods. Clarity of the recommendation or the amount of supporting reasoning also, counterintuitively, did not result in outperformance. Someone who scored at or near the top over any of those periods had no better chance of being at or near the top again in subsequent periods than any of the other sources, including those that had the worst performance in a period. That insight was one of the reasons I started looking for those rare gurus who had strong track records over long periods of time.

A second key lesson is that to be successful in investing in stocks, one needs to religiously hold onto and follow a proven strategy for the long term (at least a full market cycle of 5 -10 years or more.) This is very hard for most investors to do because most investors are not following clear strategies that are proven (let alone proven over a long period of time), and they experience a severe loss of faith during quarters, and even years, when the strategy greatly underperforms the market. Every great strategy has had down years, including Warren Buffett's, and this shakes the less faithful out. So, the lesson to me is to follow proven strategies that you can hold on to for the long term.

Kirk:  Are there any good books or other resources that you highly recommend for individual investors?

John Reese:  There are a lot of great books out there that I would recommend. A simple one that is a good place to start is The Little Book that Beats the Market by Joel Greenblatt. That book is written in a very easy to understand way, but it also gets to the core of what stock valuation is all about. It also spends a good amount of time talking about how all strategies will have bad periods and how the fact that most investors will abandon them during those periods hurts those investors' long-term returns. That is a very important point to me. and he does a good job of making it.

I also like Buffettology by Mary Buffett and David Clark. Mary and David know Warren Buffett better than perhaps anyone, and they do a great job in that book of getting to the heart of his investment principles.

Beyond that, I think One Up on Wall Street by Peter Lynch is a great book and I also think every investor should read The Intelligent Investor by Ben Graham. It is amazing that Graham's principles, which were written so long ago, still hold today, but they do. And I think any investor can learn from them.

James O'Shaughnessy's What Works on Wall Street is also an excellent book that discusses O'Shaughnessy's Cornerstone Growth and Cornerstone Value quantitative strategies and their long-term performance statistics.

Kirk:  What are some of your personal passions beyond the market?

John Reese:  I love tennis, racquetball and skiing with friends. I also have had a longstanding passion for understanding, building and learning everything that can be done with computers, and that passion gave me the skills and the tenacity to perform the research to find the best investing methodologies, and to capture the wisdom of the investing gurus in automated computer programs.

Kirk:  Finally, if you had one piece of advice to share with all investors and traders, what would it be?

John Reese:  There are two significant things I've learned over the past twelve years.

The first is that there is no magic bullet when it comes to investing strategies. When I first started Validea I was looking for the very best stock selection strategy. What I discovered is that all of these strategies can work, and trying to predict what will be the very best one going forward is not something that anyone can do.

The second point relates to the first, and it's that a quantitative stock selection strategy, like any of the ones I run on Validea, seems like it is easy and simple to follow. And, on the surface, it may seem relatively easy to implement. But despite this, very few ever realize the full benefit of following it. The reality is that there is a certain amount of work, dedication and an emotional wherewithal that most investors lack when trying to implement these approaches. So I think that if investors can learn to be disciplined and check their emotions at the door, they can have great potential for investing success.

Kirk:  Thank you John. We so much appreciate the time you've taken to offer your perspectives and market wisdom!

Those of you who would like to explore John's offerings more in detail may find the following of interest:

• Validea.com - Sign up for a free trial to Validea.com. Subscription prices: $29.95/month or $74.95/quarter or $269.95/year.

• Validea Capital Management - if you're interested in Validea Capital's private money management offering you can contact the firm at info@valideacapital.com or at (800) 730.3457. The firm's minimum investment is $250,000.

• Click here to order John's book, The Guru Investor: How to Beat the Market Using History's Best Investment Strategies.