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Stock Picks – A Question On Complexity Your Advisor Won't Want You To Ask.

There are 3 basic approaches that an investor or Stock Market Picker could take regarding the stock and equity index markets when trading or recommending stock picks:

1. Markets are random and completely unpredictable.

This is known as the Efficient Market Hypothesis and suggests that efforts to time the markets is pointless because all known information is contained in the price.

2. Markets are predictable.

This is the perspective taken by technical analysts and people who build trading systems. They believe they can identify and exploit recurring patterns in market prices due to human behaviors (e.g. fear or greed) or regularities in nature (e.g. Fibonacci sequences).

3. Markets vary in their degree of predictability.

Traders who produce a model of the markets under certain conditions but change this model when cycles change would fit in to this category.

This third cohort is perhaps the most interesting because whatever system they are using must exist at a minimum of two levels. The first level would consist of a set of predictors and an associated relationship between those predictors and results in the market. The second system would consist of a set of conditions or a process for changing the parameters of the first system as the cycles in the market change.

In Practical Speculation, Victor Niederhoffer and Laurel Kenner give an example of this as follows:

A first-order technical trading model might buy the market when the 12 day RSI moves from below 30 to above 30, and sell when the RSI moves from above 70 to below 70. A second-order trading system would consist of rules for using 21 day versus 12 day versus 8 day RSI readings for the original trading system, perhaps as a function of market volatility and "trendiness". A third-order trading system might consist of rules for categorizing markets based upon volatility or "trendiness" and assigning unique remodeling rules for each category (i.e. select from 21 versus 12 versus 8 day RSI readings for a non-trending market of high, medium or low volatility; shift from 30-70 trigger points to 20-80 and 10-90 crossover points for trending markets of low, medium or high volatility).

Through the layer of conceptual levels and complexity, the trading system gains adaptive potential. Indeed, the trader or stock picker who adheres to approach number 3 above cannot follow a single trading system, as changing cycles force the creation of a branching tree of trading approaches.

In spite of this, most trading systems today focus on just the first level of complexity (entries/exits/stops) without consideration of how these are modified as market conditions shift. To the extent that this second level of complexity is missing, a trader or someone giving stock market picks can be expected to do well under one set of market conditions and poorly in other conditions.

A straightforward application of evolutionary thinking suggests that the trader who develops more trading systems across numerous levels of complexity stands a greater chance of achieving adaptive outcomes in the market.

The idea that there are types of markets and trading systems best suited for particular market types allows for a higher number of permutations than the idea that a single set of parameters can be traded across all market.

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