How every investor can benefit from mechanical stock picking ?

Most investors prefer to pick stocks on their own rather than following a mechanical screen.

If you don't like mechanical investing, here is a strategy that can improve your stock picking.

Use a reduced Investing Universe from a mechanical screen

Simply keep on using whatever stock selection process you like but:
    1. Use a reduced Investing Universe from a successful mechanical screen
    2. Select a fair number of stocks (≥10) from that Investing Universe
Several experts propose and use this approach:


Testing on Momentum Stocks

Here is a test I've performed to check this investing strategy on momentum stocks.

First, I built a mechanical portfolio made of the Top 10% 12 months Relative Strength stocks from the New York Stock Exchange NYSE. Rebalancing is on annual basis from 1985 to 2005.

This strategy returned 21.6% annualized while an equal weighted portfolio with all NYSE stocks (#3000 stocks) returned 13.0% annualized over the same period.

Then, I created 20 portfolios that randomly pick 10 stocks among the Top 10% Relative Strength on an annual basis.

Here are the results:

Portfolio Annualized Returns
(1885-2005)
NYSE Equal weight 13.0%
NYSE Top 10% 12 months RS 21.6%
Worse Random Portfolio 14.4%
Best Random Portfolio 26.6%
Average Random Portfolio 21.0%

Stats between the random portfolios and the Top 10% Relative Strength portfolio:

Average Correlation 0.73
Average R-Squared 0.55

All random portfolios beat the market and have returns reasonably correlated to the initial high Relative Strength portfolio.

The results confirm that picking stocks using whatever technique - even throwing darts ! - from a good Investing Universe is a sound strategy.

How is this different from stock screening ?

Most investors use stock screeners to highlight investment ideas and then perform further analysis on the stocks that pass the screen.

So how's the above strategy different ?

Well, the idea here is to use your stock screener to highlight an Investing Universe that:
  • is successful by itself: not all stock screens are !
  • is large enough: ≥50 stocks whereas many screens used for Investment Ideas highlight very few stocks. See also Ranking in Stock Screening.

    Stock Ratings are alternative Investing Universes worth of consideration.

  • Subsequently, you can perform your own stock selection process, however it is important that you don't end up with too few holdings (Buy ≥10 stocks).



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