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Mining Fool's Gold

The Foolish Four is determined at the end of each year and reported on The Motley Fool Web site. Followers of the Fools are told to buy the four stocks (in the correct proportions) on the first trading day in January and hold them throughout the year. Is this advice pure gold to investors, or merely fool's gold? That is, is this a strategy that is based on some explainable mispricing in the market that can be easily captured? Or is the strategy simply the artifact of the evolution in data mining afforded to us by modern computing power?

In the 1980s, the combination of cheap computer power and availability of stock price data permitted many thousands of investors, traders, and financial economists to search for trading rules that would allow them to earn high profits. These researchers examined how many different variables predict stock returns. Think of the many possibilities. You test for the predictability of profits, profit margins, profit margin changes, depreciation, debt load, change in debt, interest payments, firm size—there must be hundreds of variables in the firm's accounting statements alone. Then, include all the possible economic variables. Also, consider all the possibilities of the past price formations. Given the noise (or randomness) of the market and the thousands of possible associations that can be tested, it is very likely that false strategies will be found: fool's gold.


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