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)