Weight of Evidence

There are numerous factors to consider when deciding to enter a trade or not. You may consider the trend, volume, the present chart pattern, or a recent company announcement for example. Many traders know that there are no perfect entry signals, but there some underlying principles that do work.

What you may also do over time, is to gain more confidence in some of your rules over others. This may also come about through some form of methodical back testing.

Using a ‘weight of evidence’ approach can add to the effectiveness of your stock selection process. What this means is that you may place greater emphasis on certain conditions over others. For example, you may have a potential company to purchase stock in and it has met most of your criteria that you have set, except two.

Those two conditions that the company has not met may not be that important to you. Even though it has not passed all of your entry criteria, it may still be determined as a suitable purchase.

Another example may be that a company ranks very highly in most of your criteria but just fails two others. The two others however, may be of utmost importance to you in your stock selection process.

As you may use weight of evidence, even though most conditions rate very highly, you would not consider purchasing stock in the company because you place such great emphasis (weighting) on those particular areas.

You could facilitate this process using a decision matrix. This matrix would list all of your criteria in the first column and in the second column, you would list each criteria’s weighting (i.e. how important it is to you). For each possible trade, you could allocate a score of between 1 to 5 for example, and then multiply the score by the relevant weighting.

For each possible trade, you would then sum the scores and be in a position to rank all of your possible trades based on your entry criteria.

In the example below, there are 3 conditions being considered and next to them are their weighting. You can see that condition B is twice as important as condition A.

Trades A and B have been assessed and the first number is the raw score between 1 and 5 with the accompanying number the adjusted score (raw score multiplied by the weighting).

After a period of time trading and developing your trading plan, you will develop a certain level of intuition and this will assist you in determining what conditions are more important than others. Over time, this will be a natural progression and will only make your selection process easier and more efficient.

A weight of evidence approach and you deciding what is important to you will assist with filtering through potential stocks when the number is large. You will be able to very quickly whittle the number of potential companies for purchase down to a more manageable number.