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 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 presented shows how each decile or quintile performed, see how they have done. This will tell you if just buying the stocks with the good traits is a profitable 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 for sources, SSRN is a treasure trove. It does not provide nor require peer reviews, but there are papers that 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 a search on authors’ names or papers’ titles on Google. I’ve seen older papers available for free online. Plus, some professors make copies of their 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 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.

What’s Trending on AAII
  1. What Is Your Investing Edge?
  2. The Trinity Portfolio: Combining Diversification, Tilts and Trend-Following
  3. CBOE's Volatility Index (VIX)
AAII Sentiment Survey

Optimism among individual investors about the short-term direction of stock prices fell to a new 2017 low in the latest AAII Sentiment Survey. At the same time, the percentage of individual investors describing their outlook as "neutral" is at a new high for the year.

Bullish sentiment, expectations that stock prices will rise over the next six months, plunged 8.9 percentage points to 23.9%. The drop keeps optimism below its historical average of 38.5% for 17 out of the last 18 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, jumped 4.8 percentage points to 41.9%. The rise keeps neutral sentiment above its historical average of 31% for the eighth time in nine weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, is 4.0 percentage points higher at 34.3%. Pessimism is above its historical average of 30.5% for 15 out of the past 18 weeks.

This week’s readings are almost exactly the same as what was registered the week before the November elections. The readings on November 2, 2016, were bullish: 23.6%, neutral: 42.0% and bearish: 34.3%.

At current levels, optimism is at an unusually low level and neutral sentiment is at an unusually high level. Both are more than one standard deviation from their historical averages. Since our survey was started in 1987, the S&P 500 has realized above-average gains over the six-month periods following unusually low bullish sentiment readings, rising in price nearly 85% of the time. There is no guarantee that this trend will continue in the future, however.

The survey period runs Thursday through Wednesday. As such, most of this week’s responses were recorded prior to yesterday’s nearly 2% decline in the S&P 500. Most of the responses were also recorded before the appointment of former FBI Director Robert Mueller as a special counsel to investigate foreign interference in the 2016 U.S. presidential election. As noted last week, we have continuously seen President Trump and the potential impact of his administration’s policies brought up in response to our weekly special questions—even when the questions have nothing to do with Washington politics.

Beyond politics, some AAII members are fretting about valuations, while others view the gains favorably. Also playing roles are this year’s lack of volatility (Wednesday’s drop excluded), concerns about the potential for a forthcoming drop in stock prices and the possibility of a significant international event occurring. AAII members, in aggregate, are not significantly altering their market outlooks in reaction to the record highs for stock prices.

This week’s special question asked AAII members what impact geopolitical and international events are having on their outlook for stocks. More than two out five respondents (42%) said such events are having a negative impact, are a cause of a concern or otherwise making them more cautious. Conversely, nearly 30% said geopolitical and international events are either not impacting their outlook or only having a small impact. About 8% said they are investing more in international stocks. North Korea was specifically mentioned by many respondents, as was President Trump.

This week’s Sentiment Survey results:

Bullish: 23.9%, down 8.9 points
Neutral: 41.9%, up 4.8 points
Bearish: 34.3%, up 4.0 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!