Chapter 8Simple Security Selection Models That Work

“At least 316 factors have been tested to explain the cross-section of expected returns…Given the plethora of factors and the inevitable data mining, many of the historically discovered factors would be deemed “significant” by chance.”

—Harvey, Liu, and Zhu (2014)1

The search for an edge in the markets is endless. There are now hundreds of papers claiming to have found anomalous returns (i.e., anomalies). The quote above is from a 2014 paper by professors Harvey, Liu, and Zhu from Duke and Texas A&M, who examine 316 “anomalous” factors. Their conclusion is that “most claimed research findings in financial economics are likely false.” However, some anomalies still pass the high hurdles for success outlined in the Harvey, Liu, and Zhu research article.

Only two factors are both statistically reliable and simple to implement by a do-it-yourself investor. These two factors are value and momentum. As evidenced in Fama and French's 2012 paper, “Size, Value, and Momentum in International Stock Returns,” value and momentum work across all markets.2 So we will all be billionaires, right? Not so fast. Let's walk through why the market anomalies exist and what traits an investor must have to exploit them.

Value Investing

Value investing has been discussed for decades and was originally outlined in Security Analysis by Graham and Dodd in 1934.3 One of Ben Graham's best students, Warren Buffett, is widely followed by the media and has ...

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