Investment strategy: unpicking stocks

There are two main types investment strategies that are being used by most of the investors. These investment strategies are index following and stock picking. An investor chooses one of these strategies and applies them to its investing portfolio. Although there are two strategies, the outcome of each strategy depends not only on the strategy, but also on the choices someone makes.

Index following

Index following is a 'passive' investment strategy. An investors chooses the index he or she likes to follow (whether it is the Dow Jones Industrial Average, the Nasdaq-100 or any other index), and aligns his or her portfolio with this index. This means that the investor buys all the stocks in the index taking into account the weight of each stock in the index. Although this investment strategy is passive, the portfolio should be realigned each time the index changes.

Another method of index following is just simply buying a mutual fund that follows the index. This will save you the effort of restoring the alignment with the index each time the index changes. A disadvantage of mutual funds is that a management fee must be paid each year.

Stock picking

The second investment strategy is stock picking. With this strategy, the portfolio is build out of individual stocks. These stocks are bought because of some individual preference of the investor. These preferences can be based on fundamental analysis (like profit or cash flow), technical analysis (such as the Relative strength or Moving average) or personal expectations.

Besides the difference in the preferences of the investors, also the process of stock picking can be different. Some investors use a mix of the different analysis techniques, others just pick their stock on gut feeling.

The only thing that all stock picking investors have in common, is that the strategy is time consuming. There are a lot of different stocks to choose from, and all the stocks should be assessed before knowing which stock is the best to invest in. All this makes the stock picking investment strategy an expensive strategy with an uncertain outcome.

Unpicking stocks

Now that you know the basis of the two main investment strategies, I would like to introduce a new strategy. This strategy is a combination of the two other strategies. First of all, you should scope the stocks you would like to invest in. This can be done by choosing the index you want. This limits your list of possible companies to invest in. This is the 'index following' part of the strategy I think is right for investing.

The second part is the unpicking of stocks. You really do not want to invest in all the stocks that are part of an index. Not all the companies in the index will perform equally. Some companies will be more successful in the future than others. The starting point of unpicking stocks is that it is possible to know which companies will not perform well. You can determine which companies have a high chance of going bankrupt (i.e. using the Z-score model) or which companies are not likely to make a profit in the coming years.

By removing the stocks you really not want to invest in from your future portfolio, you will be able to have a higher result than the index you choose to invest in. The money that is invested, can be used to only buy the good companies. You can invest the money that you otherwise would have invested in 'bad' stocks, into 'good' stocks.

Besides that it is more likely that your return is higher, unpicking stocks will save you a lot of time compared to the stock picking strategy. The number possible stocks to invest in, is smaller. And you will only need to assess which stocks you do not want to invest in. The criteria for unpicking stocks are much easier to apply and you will not have to pick only one or two stocks. And finally, the frequency of changes made to your portfolio is lower.

Tooling to use

Of course you should use your own preferences when unpicking stocks. But to help you in how to unpick stocks, three ways are given to select which stocks you do not want to buy.

As mentioned, there are some tools that can be used to unpick stocks. First of all, to determine the chances of failure of companies, you can use the Altman Z-score model.

Secondly, you can use your favourite fundamentals to determine which stocks you do not want to buy. Examples are the price/earnings ratio and the cash flow of companies.

And third, you can also use some ratios to determine whether a stock is way to expensive. For example, you could use the discount model.