Would You Trust This Stock Picking System?

Today’s Daily Reckoning will introduce you to a man who doesn’t know the names of the stocks he buys, nor the price he paid for them. Sound crazy? Maybe, but he’s making money!

How do you decide what to buy right now on the Aussie stock exchange. How do you normally do that anyway?

I bet it’s not like Tom Howard, a finance professor and investor the Financial Times profiled last week. He’s the investor I mentioned at the top. His fund has returned 66% since it formed in 2004. That’s measured against 38% for the Russel 2000 benchmark index. Not bad.

But it’s Howard’s approach that’s really interesting. He argues that we humans are our own worst enemy. What you need is a rigid control of your emotions. But we’re mostly horrible at it. Anyone who’s traded or invested in stocks can appreciate that. That’s why one of the most common mistakes is letting losses run and cutting off winning positions too early.

So what does Howard do? He burrows through the holdings of the best small funds run by young managers and works out the most popular ten stocks they hold, trusting those stocks represent their best and most compelling ideas. The rest of their holdings he regards as superfluous padding under the wrong-headed doctrine of diversification.

Then he buys the best ten. To avoid his own biases, and drawing on the insight of behavioural finance, he doesn’t look at the names of his holdings, or the price he paid. He doesn’t want loss aversion or negative sentiment to influence him. Presumably, he plays a lot of golf or lives in the woods with no internet — anything to take his mind elsewhere and resist the temptation to mess with his system.

What the article doesn’t tell us is on what basis he sells or his usual holding timeframe. But the lesson is there regardless. One of the hardest things to do in the market is master your own psychology. Howard’s is one way around that problem. There are others. Like not allowing your psychology to come into play at all.

That’s the premise of algorithmic trading. These ‘black boxes’ signal when to buy and when to sell based off the movements in the market only. That’s what Port Phillip Publishing’s latest service Quant Trader does. It generates new trades every day, long and short.

Fundamental investing guru Ben Graham would roll in his grave, but Quant trades on regardless, because it doesn’t give a damn. And that’s the point.

Callum Newman+
For Markets and Money

Originally graduating with a degree in Communications, Callum decided financial markets were far more fascinating than anything Marshall McLuhan (the ‘medium is the message’) ever came up with. Today Callum spends his day reading and researching why currencies, commodities and stocks move like they do. So far he’s discovered it’s often in a way you least expect.

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