Got Good Stocks? Prove it.

It seems obvious - but one of the keys to successful investing is to do what works.

Do what works. And don't do what doesn't.

Class dismissed.

In all seriousness, the problem many investors find themselves in is how do you know what works and what doesn't.

This reminds me of an actual conversation I had with someone several years ago who was talking about a losing stock he was in.

Kevin:
- Why are you still in it if it keeps on going down?

Losing Stock Guy:
- I don't think it'll go much lower from here.

Kevin:
- Did you think it would go this low when you bought it?

Losing Stock Guy:
- No.

Kevin:
- Do you think it'll go up?

Losing Stock Guy:
- Eventually. But probably not right away. It may still go down some more.

Kevin:
- There are plenty of stocks going straight up. Why don't you get out of that one that keeps losing you money and get into a better one?

Losing Stock Guy:
- I don't know of any better stocks to get into.

Kevin:
- What if you did know of a better stock to get into, would you do it?

Losing Stock Guy:
- Yeah, ... but I'm not sure how to find 'better' stocks.

That last comment said it all.

He was in losing stocks because he didn't know how to pick better ones.

But if he had a proven, profitable, stock picking strategy, he could.

So How Do You Know if a Strategy Works or Not?

The answer is backtesting.

But first you need a way to pick stocks in the first place.

Don't be the guy who buys a stock because it was talked about on TV or because he heard a tip from a friend.

Start with a stock screener.

Even if you don't use a screener now, most people still do their own 'screening' one way or another. They may hear that a stock has a certain growth rate, a certain P/E ratio, sales surprise or whatever.

They then find themselves listening for or reading about or surfing the Internet -- for stocks that meet these criteria.

Well if you want to find stocks that meet certain criteria, you can find them quickly and easily with a stock screener.

But, just because you narrow down 10,000 stocks to only a handful, doesn't necessarily mean that you've picked the best stocks on the planet.

You might have picked the worst ones.

But with backtesting, you can then test your screen (i.e. stock picking ideas) to see how good (or bad) your screening strategy has performed in the past.

• In other words, does your screening strategy generally find stocks that go up once they've been identified?
• Or does your screen generally find stocks that get buried once they've been identified?

This is good stuff to know.

With backtesting, you can see how successful your stock picking strategy has performed in the past, so you'll have a better idea as to what your probability of success will be now, and in the future.

Of course, past performance is no guarantee of future results, but what else do you have to go by?

Think about it; if you saw that a stock picking strategy did nothing but lose money, year after year, period after period, stock after stock, over and over again, there's NO WAY you'd want to trade that strategy or use that screen to pick stocks with.

Why?

Because it's 'proven' that it picks bad stocks.

Sure, it may turn around and start picking winners all of a sudden -- but it may also continue to pick losing stocks the way it always has.

On the other hand...what if you saw a strategy that did great year after year, period after period, over and over again -- you'd of course want to trade that strategy.

Why?

Because it's proven to be a profitable trading strategy.

And while it may start picking losers all of a sudden (now that you're using it - right?), it may also continue to pick winning stocks, just like it had been doing over and over before.

Don't get me wrong, just because you have a great strategy for picking winning stocks, it isn't going to preclude you from ever having another losing trade. On the contrary, even some of the best strategies 'only' have win ratios of 65%, 70% or 80%. (NOT 100%.)

But if your strategy picks winners far more often than losers, once you find yourself in a losing trade, you can quickly cut your losses and feel confident that your next pick will have a high probability of succeeding.

For example: in the Research Wizard program that I use, we have a strategy that comes loaded with it called 'Big Money Zacks'. The backtested results of this screen from 2000 thru 2008 (using a 1-week holding period, sans commissions and fees) showed an average annual return of over 69.5%.

Even in the bear market of 2008, it showed an annual return of 15.3% compared to the market's -37.7%.

This year? 2009? YTD, through the month of June, this strategy is up 34.7% versus the S&P 500, which is flat, or 0%, for the year.

What kinds of stocks does it pick?

Take Pep Boys (PBY) for instance. They are in the Retail/Wholesale Auto Parts industry and are a leading automotive retail and service chain.

PBY is in one of the top Zacks Ranked industries (10 out of 217). And it is one of the stars of the group with triple-digit projected growth rates and astonishingly large upward earnings estimate revisions.

Here's another strategy that comes loaded with the program - 'R-Squared EPS Growth Rate'. This one is a more conservative styled strategy (smaller drawdowns), has a longer holding period (4 weeks) and has less turnover (trades less frequently). But between 2000 and 2008, the strategy produced an average annual return of 24.5%.

What about the bear of 2008? 14.2%. Right inline with its past results.

2009 so far? Up 27.4%. Even better than its past results already.

An example of a stock that comes through a strategy like this is Fossil, Inc. (FOSL). They are in the jewelry industry and design fashion watches and other accessories.

This industry is literally the top Zacks Ranked industry out of 217 industries. And FOSL is one of the top ranked stocks within that industry with a Zacks Rank of 1.

So, is one strategy better than the other? No. They're just different. And that's the beauty of testing different strategies on your own. Or creating your own strategies and testing them out.

Put your ideas to the test and find out how your strategies have done in the past. What are their returns? What's their risk/reward ratio? What can you expect to see? How do they do in bull markets? Or bear markets? Or even sideways markets? Learn what works and what doesn't before you place your next trade. And become a better investor today.

Stop guessing. Start backtesting. And know.

Thanks and good trading,
Kevin

Kevin is Zacks' chart patterns and stock screening expert. He's in charge of the Zacks Research Wizard that empowers investors to generate market-beating stock lists at the press of a button. This software directly connects you with our constantly updated database, so you can easily create your own screens and backtests, using proprietary Zacks Rank and hundreds of other criteria.

The Research Wizard also provides many built-in strategies that are proven winners in bear as well as bull markets. These include the celebrated "Big Money Zacks" that finds hot stocks on the move. Since 2001, it has averaged a staggering yearly gain of +72.1%.

You're invited to see the latest picks from these strategies. Click here for your Research Wizard free trial.


"PBY" Free Stock Analysis: Buy? Sell? Hold?
"FOSL" Free Stock Analysis: Buy? Sell? Hold?
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