The scientific method is arguably the most important development in the history of humankind. It's a creative structure that stimulates curiosity. It pushes you to be objective, rather than emotional in your approach and it encourages you to look at the world with uncluttered senses.
It also gives you a decision-making system that, if you are faithful to it, should see you avoid pitfalls like buying high and selling low or following the crowd.
The scientific method
Incorporating a scientific framework starts with the scientific method. Let’s revisit it:
Step 1~Be curious and observe the world around you~
Step 2~Ask a question when something intrigues you~
Step 3~Do background research~
Step 4~Build a hypothesis~
Step 5~Create an experiment to test your hypothesis and run It~
Step 6~Collect and analyze the data and draw a conclusion~
Step 7~Report your findings
That’s all there is to it. Let’s see it action with a hypothetical example.
Step 1) Be curious and observe the world around you.
You notice that certain small cap bio-technology stocks periodically gap open and then continue to rise until their value has increased by at least 50%.
Step 2) Ask a question when something intrigues you.
Are there any indicators that might uncover one of these small-cap bio-tech stocks before their price begins to rise?
Step 3) Do background research
You notice in a couple of these stocks earnings drop one to three quarters before the price starts to rise.You investigate further and notice an increase in selling, general and administrative expense is the reason.
Step 4) Build a hypothesis
A small cap bio-tech company will increase its marketing spend approximately six to nine months before the release of a significant new drug or other major development.
Step 5) Create an experiment to test your hypothesis.
After careful deliberation, you decide on the following experiment:
- Create a portfolio of small cap bio-tech stocks in INVRS,
- Graph them based on price over the last five years and note the dates when prices started to increase significantly,
- Research news stories and determine the reason for the increase. Categorize the increases by reason.
- Create a template to determine the average SG&A spend over an appropriate period and compare it to the spend in the three or four quarters prior to the price run-up.
Step 6) Collect and analyze the data and draw a conclusion
After collecting the results and analyzing it you make the following conclusion:
“Of the ten instances of price increases, 80% were related to a new drug or other significant technological development and other 20% were related to a take-over announcement. Of the eight related to innovation and in the nine months leading to the price increase, one increased their SG&A spend by 5-10%, five increased it by 11-20% and two increase it by more than 20%.
Based on this evidence, I conclude that an increase in SG&A spending is a leading indicator of a price increase for small-cap bio-tech stocks.”
Step 7) Report your findings
Write a blog, article or white paper about your findings.
The process can be iterative
You don’t have to stop after the final step. Whether you prove your hypothesis or not, you can go back and do more research, tweak your hypothesis, or refine your experiment.
In the example above, a next step might be to create a test for false positives. Or in other words, measure the likelihood that an increase in SG&A doesn’t lead to a future price spike.
What about profit and market advantage?
Clearly the degree to which you publish your ideas might be limited by economic constraints. You might want to keep certain ideas to yourself, so the reporting might be to a small group or you might take a position first or put a paywall around your work.
I hope this article gives you some ideas about how you can use the scientific method in your investing. We'd love to hear your stories about using it.