Evidence-Based Investing - What Is It?
You've probably heard the term evidence-based investing. Sounds like a logical approach, right? But what does this term actually mean? What qualifies as "evidence" and how should it be applied?
What Is Evidence-Based Investing?
Evidence-based investors build and manage their portfolio based on what is expected to enhance future returns and/or dampen risk exposures, according to the most robust evidence available, supported by unbiased academic studies. An evidence-based investor also sticks to their strategy once it’s in place, despite the market’s uncertainties and doubts they inevitably encounter along the way.
Evidence-Based Investing, Applied
Do you hope …
Investors 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 …
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 concrete factors, 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?
So far, so good. Then again, at first blush, nearly every investment recommendation may seem “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’s usually 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’s nothing wrong with facts and figures. The critical factor is how we apply them as evidence-based investors. 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 adds substantive value to our decisions by refuting or adding to the existing evidence? Which is just noise, to be ignored by the evidence-based investor?
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’s 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’s in an Evidence-Based Name?
Last but not least, it’s worth mentioning that others may refer to the same or similar approaches by various names, such as factor-based, asset-based, or science-based investing. These terms are relatively interchangeable, but there’s a reason we’ve chosen evidence-based as our preferred expression. Heeding sound reason and rational evidence is at the root of what we do. Therefore, we believe it should be at the root of what we call it.
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.
This content is developed from sources believed to be providing accurate information as of the date of publication, and is intended for informational purposes only. Please consult your financial professionals for specific information regarding your individual situation. Past performance does not guarantee future results. All investing involves risk, including risk of loss.