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After reading dozens of books about human trading and Automated Trading, I feel like one of the biggest shortcomings of trading books is that the strategies are not very well tested. Although each author seems to swear by their systems and indicators, they rarely present any real evidence that their systems work. They do present charts that are handpicked to show when their system worked, but they conveniently ignore any evidence when they don’t work. And, they rarely show a track record of trades so we have an idea of how often it might work in actual trading.

I agree with the authors of Empire of Debt, when they say that trading the markets is not a science, and not even an art. I wonder if it might just be voodoo, where nobody bothers to really find out how successful trading systems are. But that is a topic for another post.

Why am I starting this post about the problems with books about trading? Because The Little Book That Beats the Market is a pretty good exception. Not only does it avoid many of the tricks used by most trading books, the author even explains 7 common faults with trading systems, and how his system has avoided these faults. I found this a singular and refreshing explanation of the rigor of  the methodology used in trading books.

How does he do it?

Since I have started this post with a rant about trading books, here’s the 7 common problems that the the author points out that systems tend to have:

1. The data used to select stocks wasn’t available at the time (look-ahead bias)
2. Companies that went bankrupt were removed (survivorship bias)
3. Share volume is so low that shares could not likely be purchased at quoted prices
4. Ignoring significant transaction costs
5. Choosing stocks that are riskier, and therefore they outperform
6. Choosing stocks through backtesting (data mining)
7. Information from previous studies was used. This information was not available at the time the stocks would have been traded.

So that’s one reason I recommend this book: the author makes a serious attempt at creating something that will actually work. And, as far as I can tell, everything that the author says seems true. Another important point is that the author has a conversational and fun style, showing that he is writing from his heart.

What is the system?

The author, Joel Greenblatt, has created his “Magic Formula”, which recommends choosing stocks based on 2 simple criteria, and holding them for one year, give or take a few days.  This holding period is actually a serious advantage. It allows us to take losses at a higher tax rate than our profits. So, that is one way to stack the cards in our favor.

Another great thing about the system is that it is very simple. It uses just 2 criteria: Return on Capital and Earnings Yield. These 2 criteria are actually not very often offered in stock screeners, but that is not what is great about them. What is great is that there are only 2 criteria (instead of 127 chosen to make the system look good but virtually guaranteed to lose money in practice), and that they are plausible predictors of companies likely to rise in value in 1 year.

Although the 2 criteria are not available on many stock screeners, they are available on the author’s website, Magic Formula Investing. In addition, he offers a few similar criteria that are widely available in stock screeners.

What’s not great about the book?

The only problem I found with the author’s methodology is that it only covers the last 17 years. That is a short time for the stock market, and many people think it is going to have some serious transitions in the near future. A depression happens every 80 years on average, and if we do have a depression in the near future, I don’t know if his system will work well. It is possible that it will do OK, since it has performed relatively well in down markets. But it is also possible that the scale of the future down market will cause the system to lose significant amounts of money.

To wrap it up, I would definitely recommend reading this book to anyone who is interested in using or developing trading systems. In fact, I think it is a good book for anyone who wants to improve their financial situation or become a better investor.

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