Stock-Picking Isn't Just A Guessing Game

Includes: AAPL, AMZN, GM, MCD, VZ
by: Kurtis Hemmerling

In January, the American Association of Individual Investors polled its subscribers to find out how many used a quantitative selection methodology when investing in stocks. To get some perspective, AAII is largely focused on filtering stocks based on fundamental data and rebalancing monthly. You would assume that virtually all its subscribers would use some form of quantitative analysis. Oddly enough, the results were:

  • 37% used it
  • 44% did not
  • 19% did not invest in individual stocks

My question for the majority of investors is this: How are you selecting stocks?

Investing in Products You Use

After a little digging through some message boards I found that many people invest in companies that produce the goods and services they consume and use. One individual buys shares in General Motors (NYSE:GM) because he drives a Chevy, owns stock in McDonalds (NYSE:MCD) since his family members love the dollar menu and invests in Verizon (NYSE:VZ) because that is his phone carrier. Is this a sound way to trade? Actually, it might be better than taking a hot tip from a friend.

What drives us to buy certain products and services? Clever advertising, superior product and market dominance are common factors. What prompted you to purchase the product could also be the edge that keeps it ahead of the competition in the future. Choosing a quality leading product or service isn't a terrible way to invest, and it follows a widely used principle of investing in what you know.

What is the Buzz

Some invest in companies that are being talked about in the news. It could be the hot stock like Apple (NASDAQ:AAPL) with the countless daily articles written by authors wondering what could possibly follow the success of the touch phones and tablet computers. Or maybe some are following the rival Kindle Fire by Amazon (NASDAQ:AMZN) that is produced close to cost in an aggressive attempt to gain market share from Apple. My personal take is that this type of news investing may not produce the best long-term results without accompanied fundamental analysis. Why?

Stocks that are all the rage get a huge boost in investor dollars and associated volume. While buying high-volume momentum stocks is a strategy that has been linked to market beating gains, these stocks typically reverse their gains over the following two to three years. If you invest by what is in the news, just be ready to jump ship when the company is no longer the flavor of the week and investors are putting their dollars into the next high-growth sensation. It sort of reminds me of a long, drawn-out pump-and-dump operation carried out by analysts and investment news providers where prices and volume surge for a year or so due to the wide coverage, followed by a slow death. Think dot-com boom to bust.

Using Quantitative Analysis

With the stakes so high, why do so few investors dig into the financial numbers? Does it seem too overwhelming to sift through thousands of stocks to find suitable candidates? Do some view the link between fundamental analysis and portfolio gain weak at best?

Since we are talking about your future and retirement, why not start by reading a quantitative analysis book, get a free membership to stock screening and backtesting service such as Portfolio123 and test out some clever strategies? Prove to yourself that you can gain a profitable edge by using sound investing concepts and computer-assisted screening of massive databases to shortlist your potential candidates. Furthermore, these methods need not be exclusive; you can still pick companies that you are familiar with from the stock screening recommendations.

My final suggestion is that you have very little to lose and a lot to gain by doing a little extra research and due diligence into quantitative investment strategies. What is your method for picking stocks? Please comment below and share.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.