August 18th marked the second anniversary of the debut of my All-Cap Value portfolio on Covestor. The portfolio rose  21.6% YTD (net of fees) ending July 31st, 2013, versus 19.62% return for the S&P 500 Index for the same time period.

My original strategy was to focus exclusively on buying stocks in high quality companies when they became available at attractive prices. My policy was to put between 5% to 20% of my portfolio into each position.

While I didn’t expect high-quality large caps to stay as attractive as they were from 2009-2011, I was confident that I could always find plenty of affordable quality names across my broad universe.

As we entered 2013, it was becoming more and more clear to me that I was being too rigid with respect to my quality requirement and position size minimum.

Quite often, good value can be realized from purchasing cheap, out-of-favor stocks of companies with uncertain business prospects. The tendency of companies that have underperformed in the past to improve is known as “mean reversion.” The tendency of investors to undervalue the stocks of companies with uncertain future prospects is known as “uncertainty aversion.”

Mean reversion and uncertainty aversion can be a potent combination. If an investor analyzes an out-of-favor business and determines that the company’s future prospects are in fact merely “uncertain,” and not simply “lousy,” then the stock might represent an attractive opportunity.

But mean reversion is not always the operable model, so when the investors’ conviction level is only moderate, the optimal strategy is to make multiple investments, keeping position sizes relatively small.

This rethinking constitutes a broadening, and not a reversal, of my portfolio strategy. I am still willing to take more concentrated positions in higher quality undervalued names when I am confident that I have a clear understanding of how the business works and why the stock is undervalued. I don’t know of any credible reason why these variants of the value investing approach should not be combined in a single portfolio.

While my investment strategy has evolved, my objectives for the portfolio remain the same. My personal goal of beating the S&P 500 Index by at least 5% on an annualized basis over all rolling five year periods remains the same, as does my secondary goal of preserving purchasing power after fees and taxes in each rolling five year period.

The secondary goal is necessary because I will not be satisfied with besting the S&P if the index fails to keep pace with inflation.

I expect to potentially outperform the index in both bull and bear markets on average over all five year periods, though I expect to post negative returns in most bear markets and to frequently underperform over shorter time frames.

In the parlance of portfolio theory, I expect the All-Cap Value portfolio to deliver healthy doses of both beta and alpha. I believe that is one of the best routes to building wealth in the stock market in the long-run, provided that one can tolerate the volatility that goes along it.

In the interest of clarification and disclosure, I am merely describing what I intend for the portfolio to achieve. Returns are never guaranteed, and despite my best efforts, the portfolio could both lose money and underperform over any future holding period.

Certain information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The manager believes that such statements, information and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.