Use any alpha

There can be two reasons why two investments exhibit a particular correlation over a certain period of time: either a fundamental, robust reason or simple randomness.

If you decide to flip a coin ten times in a row, and repeat the experience 1,024 times, there is a good chance that once out of a thousand times you will get ten heads in a row, and once ten tails in a row. That will not carry any particular meaning.

To demonstrate the concept that correlation doesn't mean causation, a European university professor found two similar distributions: the number of storks observed in central Europe since World War II, and the fertility rates of the population over the same time period. Does this mean that storks bring babies? Of course not.

Now let's look at the correlation between the U.S. dollar and gold for the last 22 years; we get a value of -0.61. According to the Bureau of Labor Statistics, the U.S. dollar has lost about half of its purchasing power over the same time period. Could it be that investors see gold as a store of value, while the dollar depreciates constantly? While impossible to prove, the theory makes some sense.

Once you understand the concept, it's time to start looking for alpha. For example, you probably know that every corporate insider buying or selling shares of a listed company has to file the proper documents, freely available to the public. Studies show that companies with constant insider buying outperform those with heavy insider selling.

The nice thing is this: current statistics show that 38 out of 39 investors only know how to make money when a stock goes up. In other words, only 2.6% of the market players make use of the potential downside performance.

In the above example, that means that 38 out of 39 people who look at insider transactions either buy a stock along with the insiders, or avoids shares with insider selling. If you look for insiders massively dumping shares, in order to profit from future lower stock prices (with only half the money, of course, to remain market neutral), you'll avoid the crowd.

Except for us, who noticed Covad (-92%), InfoSpace (-84%), DoubleClick (-72%), Foundry Networks (-90%), Sepracor (-66%), HomeStore (-86%), FreeMarkets (-78%), Manugistics (-80%), Applied Digital (-76%), Vaso Active (-89%), Maxim (-70%), NorthWest (-84%) and a few other corporate insiders heavily dumping shares?

All this alpha is just sitting there waiting, and 97% of the market isn't even looking at it. Shouldn't you take advantage of it?