Tips for Using Academic Research About Investing
Thursday, May 18, 2017

There is a constant stream of new academic research about investing. Some of the papers attempt to explain the key drivers of returns. Some are more focused on investor behavior. Many papers are focused on realizing higher returns (“delivering alpha”). For an investor seeking new ideas, these papers can range along a spectrum from being very helpful to being completely useless to being somewhere in between. It depends on the paper and what specifically a person is looking for.

There are many of us who cite this research regularly. Larry Swedroe does so regularly on ETF.com. Jason Zweig often tweets out links to research. It’s also not unusual to see him reference academic research in his Wall Street Journal column, The Intelligent Investor. I mention papers in this weekly commentary and in the Briefly Noted section of the AAII Journal. The three of us are not alone in writing about academic research related to investing.

I’ll get to sources in a moment, but first I want to add some cautionary statements. When it comes to drivers of outperformance, such as for selecting stocks, it’s impossible for individual investors to mimic the stated performance in papers. The returns are often presented in some form of good versus bad, where the stocks with the "good" traits are purchased and the stocks with the "bad" traits are shorted. Furthermore, the returns calculated are typically based on a very large number of stocks grouped by deciles (10 groups) or quintiles (5 groups) ranked according to what’s being tested (e.g., lowest to highest valuation.) It’s impossible for individual investors to implement such strategies. Due to liquidity constraints, it’s not easy for institutional investors to do so, either. There is a work-around, though.

If the data is presented showing how each decile or quintile are shown, see how they have done. This will tell you if simply just buying the stocks with the good traits is a good strategy in itself. You want to focus on whether the outperformance is large enough to solely follow the buy-only (“long”) part of the strategy or if the findings are based on going both long and short. Also, pay attention to the period tested. Daily returns aren’t going to help you and neither are weekly numbers. Monthly returns are not uncommon, but annual returns are better. You don’t want to implement a strategy that will have you constantly trading.

Regarding the use of deciles, research on security selection frequently uses a ranking system. Those of you comfortable with spreadsheets (and in some instances, math) can replicate what is being done. The alternative is just to incorporate the criteria into a general screen without ranking parameters. It’s not as precise, but it can often get you into the ballpark.

The research on portfolio management in some ways tends to be easier to implement. The big thing is to pay attention to what’s usable from your perspective and what’s not.

When reading research, understand that these papers are not written for individual investors, much less the lay public. There is an academic style of writing that can be taken too far at times. I’ve read papers where it seems like the writers pulled out the thesaurus to find esoteric words when layman’s terminology would have worked just fine. I’m not talking about phrases such as “ex ante” (before the event) and “ex post” (after the event) or statistical terminology, but words that will require most people to reach for the dictionary. If you can’t understand what’s being described in the abstract, move on. You probably won’t understand the full study either. Plus, there’s much other research to look at.

As far as sources, SSRN is a treasure trove. It does not provide nor require peer reviews, but there are papers which appear on it first and then are accepted for publication in one of the financial industry’s peer-reviewed journals. Some papers are free, while others require registration or purchase. I’ve also seen abstracts for papers that are not available for download. ScienceDirect has industry journals and accepted manuscripts on it. Many of its articles are behind a paywall, however, with prices varying by paper. The CFA Institute’s Financial Analyst Journal makes the most recent 12 months of its articles accessible to the public. An alternative is to do an online search. I’ve seen older papers available for free online. Plus, some professors make copies of the research available for download on their personal or university websites. This is not a universal practice, but it may be worth a shot.

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Highlights from this month's AAII Journal

AAII Model Portfolio Update

 No changes were made this month to either the Model Shadow Stock Portfolio or the Model Mutual Fund Portfolio. Just two Shadow Stock holdings currently qualify as buys: Salem Media Group (SALM) and Seneca Foods (SENEA). Ultra Clean Holdings’ (UCTT) book value was above the 3.0 limit as of the end of April.

This Model Shadow Stock Portfolio posted a 3.7% gain in April on the heels of gaining 3.4% in March. The portfolio continues to buck the trend of small-cap and value-oriented methodologies as the Vanguard Small Cap Index fund (NAESX) climbed 0.8% for the month and the DFA US Micro Cap fund (DFSCX) added 1.6% in April. The Model Fund Portfolio added 0.6% in April, compared to a 1.0% monthly gain for the SPDR S&P 500 ETF (SPY).

The Week Ahead

First-quarter earnings season begins to wrap up, with 18 members of the S&P 500 scheduled to report. Among them are eight retailers: Advance Auto Parts (AAP), Lowe’s (LOW) and Tiffany & Co. (TIF) on Wednesday; and Best Buy (BBY), Costco Wholesale (COST), Dollar Tree (DLTR), Signet Jewelers (SIG) and Ulta Beauty (ULTA) on Thursday.

The week’s first economic report will be April new home sales, which will be released on Tuesday. Wednesday will feature the May PMI composite flash, April existing home sales and the minutes from the Federal Open Market Committee’s policy May meeting. April international trade data will be released on Thursday. Friday will feature April durable goods orders, the first revision to first-quarter GDP and the final University of Michigan’s May consumer sentiment survey.

Six Federal Reserve officials will make public appearances: Minneapolis president Neel Kashkari on Monday, Tuesday and Wednesday; Philadelphia president Patrick Harker on Monday and Tuesday; Chicago president Charles Evans on Tuesday; Dallas president Robert Kaplan and St. Louis president James Bullard on Thursday; and San Francisco president John Williams on Sunday.

The Treasury Department will auction $26 billion of two-year notes on Tuesday, $13 billion of two-year floating rate notes and $34 billion of five-year notes on Wednesday and $28 billion of seven-year notes on Thursday.

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AAII Sentiment Survey

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This week’s Sentiment Survey results:

Bullish: 23.9%, down 8.9 points
Neutral: 41.9%, up 4.8 points
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Historical averages:

Bullish: 38.5%
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Bearish: 30.5%
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