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A Guide to Creating A Successful Algorithmic Trading Strategy by Perry J. Kaufman

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CHAPTER 14 Picking the Best Stocks (and Futures Markets) for Your Portfolio

I wish it wasn’t so, but I don’t have enough capital to trade all of the stocks in the S&P 500 using my strategies. I need to select stocks that will outperform the average, hopefully by quite a bit. I’ve heard this called “smart beta,” which is also “alpha.” So we’re adding considerable value if we can do this right.

ASKING TOO MUCH

We keep coming back to realistic expectations. Some years ago I spent considerable time developing a classic portfolio allocation program, more or less based on Markowitz’s mean-variance approach. In that method, you found the optimal portfolio based on risk, reward, and correlation. That method was the industry benchmark for years. We won’t discuss it because there is no proof that I’ve found that says it has any predictive value. It simply finds the best combination based on past data. We’d like something that actually does better than the market index in real trading.

Being skillful at programming and math, I decided that the best portfolio was not only the one with an excellent return, but one that varied the least from the steady upward progress of returns. Another way of saying that is I wanted the returns to look as close as possible to a straight line going up.

As it turns out, with enough manipulation of data, weighting the trades to emphasize the winning ones and avoiding those that have large equity swings, you can get a very impressive result. Unfortunately, ...

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