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Wealth & Well-Being

What is Evidence-Based Investing?

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If you have read much of our work, you have probably noticed we embrace evidence-based investing. But what does that mean?

1) Evidence-based investors build and manage their portfolio based on what is expected to enhance future returns and/or dampen related risk exposures, according to the most robust evidence available. This includes Nobel prize-winning theory, historical evidence, and scholarly research.

2) Evidence-based investors maintain a long-term investment strategy, despite market volatility and uncertainties along the way.

Evidence-based investing is more than meets the eye. Behavioral strategies must be in place to support the evidence-based approach. Investors who take the evidence-based approach to investing do not try and time the market by jumping in and out of investments whenever volatility strikes. They also do not gamble their income on short-term, fad “investments” that come and go out of fashion.

As Dimensional Fund Advisor’s David Booth asserts, “Where people get killed is getting in and out of investments. They get halfway into something, lose confidence, and then try something else. It’s important to have a philosophy.”

Do you hope …

  1. Investors can come out ahead by finding mispriced stocks, bonds, and other trading opportunities; and/or by dodging in and out of rising and falling markets?

Or do you accept …

  1. The market’s rapid-fire trading creates relatively efficient pricing that is too random to consistently predict?

There is an overwhelming body of evidence suggesting investors should skip the first approach and act on the second assumption. This has been the case since at least 1952, when Harry Markowitz published Portfolio Selection in The Journal of Finance. In their book, “In Pursuit of the Perfect Portfolio,” professors Andrew Lo and Stephen Foerster describe:

“While it’s commonplace now to think of creating a diversified portfolio rather than investing in a collection of securities that each on their own look promising, that wasn’t always the case. It was Harry Markowitz who provided a theory and a process to the notion of diversification. He helped to create the industry of portfolio management.”

Markowitz’s work became known as Modern Portfolio Theory (MPT). Academics and practitioners have been building on it ever since. His initial work and others’ subsequent findings strongly support ignoring all the near-term noise and taking a long-view approach. This involves building a unified investment portfolio, and focusing on more manageable details, such as:

  • Tilting toward or away from entire asset classes to tailor your risks and expected returns
  • Minimizing avoidable risks by diversifying globally
  • Reducing unnecessary costs
  • Controlling your own damaging behavioral biases

How Do You Decide Which Evidence to Heed?

It may seem as though nearly every investment recommendation is “evidence-based.” After all, few forecasters would peer into actual crystal balls to make their predictions. And no market guru would admit their stock-picking track record has been no better than a dart-throwing monkey’s (even though that is often the case).

Instead, stock-picking and market-timing enthusiasts tend to argue their cases by turning to articulate analyses, smart charts, and convincing corporate briefs. They use these props to explain the late-breaking news, and recommend what you should supposedly be doing about it.

There is nothing wrong with facts and figures. The critical difference is how we apply them as evidence-based investors. As financial author Larry Swedroe describes it:

“In investing, there is a major difference between information and knowledge. Information is a fact, data, or an opinion held by someone. Knowledge, on the other hand, is information that is of value.”  

— Larry Swedroe, ETF.com

No matter how compelling a call to action may be, we discourage frequent reaction to the never-ending onslaught of information. First, we must determine:

  • Which information might add substantive value to our decisions by refuting or adding to the existing evidence?
  • Which is just more of the same old noise, already factored into your evidence-based investment strategy?

The Evidence-Based Silver Bullet: Academic Rigor

Because there is a lot more noise than there is valuable knowledge, the basic recipe for evidence-based investing begins and ends with academic rigor. It should always be a key ingredient in separating likely fact from probable fiction:

  • It requires robust data sets that are large enough, representative enough, and free from other common data analysis flaws.
  • Authors should be impartial, lacking incentives to massage the data to make a point.
  • Other studies should be able to reproduce the same findings under different scenarios, suggesting the results are more likely to persist upon discovery.
  • The data, methodology, and results should be published in reputable, peer-reviewed forums where informed colleagues can comment on the findings.
  • Enough time must pass to make all of the above possible.

After that, we also must be able to apply the results in the real world. In other words, even if a theoretical strategy is expected to enhance your returns, it must do so after considering all practical costs and portfolio-wide tradeoffs involved. For example, sometimes one source of expected returns may offset another, even bigger source. Sometimes, we can combine them for even stronger results; other times, it is best to favor one over the other.

Evidence-Based Investment Factors

So, which factors appear to best explain different outcomes among different portfolios? In what combinations are these factors expected to create the strongest, risk-adjusted portfolios? What explains each factor’s return-generating powers, and can we expect those powers to persist?

Based on the academic answers to these practical questions, we typically mix and match the following factors in our evidence-based portfolios, varying specific exposures based on each investor’s personal goals and risk tolerances:

  • The Market: Stocks (equities) vs. bonds (fixed income)
  • Company Size: Small vs. large company stocks
  • Relative Price: Value vs. growth company stocks
  • Profitability: High-profit vs. low-profit company stocks
  • Term: Long-term vs. short-term bonds (based on maturity date)
  • Credit: “Safer” vs. “riskier” bonds (based on credit quality)

What would your best evidence-based investment portfolio look like? It depends on your personal financial goals; as well as your willingness, ability, and need to take on investment risks in pursuit of those goals. That’s where we come in, to structure the right mix for you, and help you navigate through the ever-distracting informational overload.

If you feel your current investment philosophy is not aligned with your long-term investment goals, one of our Certified Financial Planner™ professionals would love to discuss the benefits of evidence-based investing with you. Contact us today for a complimentary Get Acquainted meeting. We look forward to meeting you.

Written by Alexa Darbe in collaboration with Lexicon Content Development

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