How To Tell A Good Stock Picking Strategy From A Faulty One

Okay, so Jack Hough’s column in SmartMoney this week is really just an extended ad for his new book. But in this case, the content of the book is something valuable that we think a lot of Consumerist readers will want to know about: how to identify reliable stock picking strategies.

For instance, he dissects the way mutual funds are created, culled to isolate the best-performing ones, and then marketed as if they’re built on sound strategies and not luck:

The mutual-fund industry was all but founded on [survivorship bias]. Firms create (“incubate”) far more funds than they need and fill each with different investments. Some win, some lose. Guess which ones go on to get marketed and which get quietly closed? Decades of research have shown that the average managed stock fund falls miserably short of the broad market’s returns. Yet survivorship bias ensures a constant supply of magazine ads with splashy performance figures. Dead funds tell no tales.

Hough says a good stock picking strategy should meet five qualifications:

  • they’re based on a strong correlation
  • they’re based on logic
  • the strategies are carefully screened to eliminate survivorship bias and to ensure the clue in question is the best explanation for what’s happening, and not some other, hidden variable
  • the strategies are practical
  • the strategies can be reduced to the language of stock screeners

Of course, he saves the actual strategies for the book, but says he’ll excerpt two of them in future columns over the next couple of weeks.

“Author Debunks Financial Parlor Tricks” [SmartMoney]
(Photo: Getty)

Comments

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  1. BigNutty says:

    Save your money. I have the best advice you could ever hope for in regards to the stock market. Buy Low and Sell High. There. You will now become rich.

    But if you would like to practice in learning how to make money in the stock market, there is a website called [www.bigsmarty.com] that provides FREE trading contests and gives away $50,000 in real cash prizes per month.

    Winners get bragging rights, money but best of all, the opportunity to become a trader with the added value similar to the “American Idol” fame.

    No, I don’t make anything from mentioning them. I just think consumers should know about any good deals out there.

  2. redx says:

    From the academic research I’ve read, poor mutual fund performance persists but good mutual funder performance only persists for 1 year after the doing well. So buy a good mutual fund that worked last year but sell it within that 1 year.

  3. Miguel Valdespino says:

    That’s why I like index funds. The performance may not be as high as some other funds, but their costs are so much lower that I usually do better than my friends that choose other funds or that manage their own portfolios.

  4. Trai_Dep says:

    Broad-based index funds w/ low maintenance fees. Hang on to them, buying in incrementally. Diversify.

    The end.

  5. mconfoy says:

    Our favourite holding period is forever.
    Warren Buffet

  6. Myron says:

    There are no reliable stock picking strategies. There is luck and temporary success. If anyone had a way to reliably beat the market they would be the richest person in the world.

  7. courtarro says:

    What if I pick this stock picking strategy and it turns out to be unhelpful? What if, as a result, I end up not picking the right picking strategy, and that strategy would have earned me a lot of money? It sure is hard picking the right picking strategy!

  8. Rusted says:

    @mconfoy: Amen to that. Warren Buffet is someone who everyone should study.

    No system needed unless one counts cards…..

    Stock picking or mutual fund selection isn’t rocket science. I go back at least five years and look for a steady progression in value. Like Mr. Buffet, I am suspicious of sudden gains in value as well as losses. I hold it for a long time. I currently have vhgex and vtrix from Vanguard and dodgx in my 401K. Can’t complain.

  9. redclear55 says:

    stock picking strategies are as prevalent as there are stocks. unless you have enough assets, time and knowledge to buy individual stocks, you are better off investing in mutual funds and exchange traded funds. they key word is diversification. how you balance your portfolio between the various asset classes depends on your risk tolerance.

    speaking to performance characteristics, you need to be cognizant of the overall market during those time periods. you should weigh more analysis on risk-adjusted returns versus it’s peer universe. sharpe ratios and capture ratios are just two commonly used tools.