One Piece Of Advice For 2014: Be Skeptical

| About: SPDR S&P (SPY)

If I had to give only one piece of investment advice for 2014, and beyond, it would be to know and deeply understand the bear case against all of your investment positions. This is particularly true if you are getting your initial investment ideas from financial periodicals, sell-side research reports, or blog articles -- as these sources will, obviously, have a strong bias (as is the nature of investment recommendations).

Too often, I find recommendations on complex investing ideas that overstate the investment case and ignore or understate the risks. This is particularly true with respect to recommendations on companies in less understood emerging markets (where the companies face very specific competitive market dynamics and unique geopolitical and sovereign risks) options/derivative trade ideas, and special situation investments.

As a result of this inherent bias, I've seen investment recommendations produce substantial spikes in the prices of stocks (particularly small-cap stocks (NYSEARCA:IWM)), only to have the prices then come right down again once the excitement over the recommendation subsides and all of the facts and risks come to light. As it oftentimes turns out, that emerging market company isn't really that cheap (even though it has an attractive 4x P/E ratio), that complex option trade doesn't really give you all of the upside of the stock with virtually no downside, and that special situation warrant is actually priced pretty efficiently, despite the limited liquidity and visibility of the instrument.

After reading an investment recommendation, your starting point for investigating the idea should be from a position of skepticism rather than enthusiasm. A key to finding a good investment opportunity is not only understanding the investment case but, perhaps even more importantly, deeply understanding the opposing viewpoint. Before investing, you should have a solid understanding of this differing viewpoint and a strong conviction as to why you believe that the opposing rationale is wrong. If you can't find or don't understand the opposing/bearish viewpoint, don't invest until you do.

While this advice may seem somewhat obvious, and most investors do engage in some critical examination of their investment ideas, the critical research that's done often isn't enough. Furthermore, once an investor makes their initial investment, they can tend to seek positive affirmation rather than seeking all relevant feedback, equally. In doing so, they may focus too much on finding supporting views for their investment positions and they may be too quick to dismiss or ignore opposing views (as opposed to seeking them out and fully exploring them).

To illustrate this point, it's interesting to read the analysis of earnings reports from both bullish and bearish analysts and bloggers on the same company. It's often as if they were looking at completely different earnings reports. The bullish analysts will primarily see and report on the positives while the bearish analysts will do the opposite. This is a natural tendency that all investors must work to overcome and there are many ways to do so.

If you have access to sell-side research, find an analyst with an opposing view and study their research. If you don't have access to that type of research (as it's typically only available for institutional investors), a good source for finding opposing views can be from bearish articles on financial blog sites like Seeking Alpha or The Street, or the comment section of a bullish article (even trolls can sometimes add value!), or even a Google (NASDAQ:GOOG) search using key words that may produce links to more bearish views.

Most importantly, you should always do your own vigorous scrutiny of the investment thesis with a view to finding holes in the recommendation. A good exercise for doing so is to try and articulate the opposing view as convincingly as you can -- as if you are being paid to make the most compelling argument possible supporting that opposing view.

By really scrutinizing the rationale of someone else's investment recommendation -- regardless of how credible the source and how well articulated the idea -- you can help to avoid buying in on recommendation-induced euphoria that's unjustified and short-lived. Furthermore, this type of investment approach can increase your conviction in your existing investments by helping you to better understand the risks of your positions.

Best of luck to all in 2014 and stay skeptical!

Disclosure: I am long IWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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