Why you should avoid following just one investment indicator found in research studies or elsewhere

While research studies can provide perspective, they rarely provide investment indicators you should bet on.

Investment indicators can easily restrict your field of view. That’s why they so often wind up hurting your results: when you focus on too little information, it’s easier to miss something important. Rather than narrow the range of facts you consider, it’s better to look at a wide variety of information. Then, emphasize the facts that seem to have the most relevance to the stock or business you are considering.

For example, insider buying and selling on public information is one of many factors worth considering when evaluating a dividend stock. But it’s a mistake to put too much weight on it—or any one or two investment indicators, or types of investment information. 

When you look at stocks to buy for your portfolio, use investment indicators to assist you in  making a sound investment—but not as the sole factors

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Quality is one of the most important investment indicators

You have to keep in mind that investor expectations routinely range more widely than investment outcomes. This applies to stocks as much as it does to the stock market. If you buy when investor expectations are low, it tends to cut your risk, especially if you stick with well-established investments.

Our primary advice is that you should aim for investment quality and diversification. At any given time, lots of prosperous, well-established companies are out of investor fashion. Some of the biggest profits you ever make will come from buying these stocks before they find their way into the limelight.

Investment indicators can come out of research studies, but approach with skepticism

Many investment theories and fads come out of academic research. Researchers come up with an idea for what they see as an “anomaly”—some economic or investment pattern that can be harnessed to generate above-average investment returns, or what some would call “free money.” They then subject the idea to statistical analysis, to see if it might work out in the real world, and not just in theory.

It pays to look on this kind of research with a healthy degree of skepticism. Statistical analysis only goes so far. Even if the anomaly existed and could have generated great profits in years past, it can disappear as mysteriously as it appeared.

One crucial drawback to this kind of research is that the incentives skew the findings toward a positive conclusion. If the analysis suggests the idea can make money, it can open the door to academic acclaim, career advancement, and high-paid business opportunities in hedge funds and other investment areas. But there are no offsetting negative consequences. If research shows the idea is a loser, researchers can forget about it and move on to something else.

For instance, one academic study, entitled “Replicating Anomalies,” looked at 447 theoretically profitable anomalies that have many followers in the investment world. The study concluded that profits from more than half of these supposed money-makers are little more than figments of their discoverers’ imaginations. The study’s authors, Kewei Hou, Chen Xue and Lu Zhang, found that these anomalies work best, if at all, on tiny microcap stocks, where trading costs exceed the profits that are supposedly available.

In fact, they found that nearly two thirds of the market patterns could not be replicated, 95% of the time. You have to wonder if popularizers of these false profit-makers “cooked the books”—that is, tailored their statistical samples to ensure a positive result, even if that meant it was non-reproducible.

This approach is sometimes referred to as, “first you shoot the arrow, then you paint the target around the spot where it landed.”

The study found that even widely followed investment themes such as momentum, small-cap and value investing have lost most if not all of their investment mojo since becoming popular. (This should come as little surprise if you have followed the results of advisors that specialize in these routes to profit.)

So should you look to research studies for investment indicators of success or failure? It’s clear that you may want to take this widespread failure of investment research as an indictment of the financial industry, or of the investment branch of academia. In fact, it more likely says something about human nature. Researchers in all sorts of fields delude themselves when they carry out research that can make them rich and famous.

This applies not just in the soft science of investment, but also in studies of cancer, diabetes, physics and other hard-science areas.

Trusting research as a true show of positive or negative investment indicators could be problematic, depending on where the information is coming from. Which research do you trust, and which do you not?

Too many investors have gone astray by trusting a small portion of market indicators or stock research. If you’ve made that mistake, what did you do to get back on track?


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