How do you invest your money over the long term? If you’ve read much of our work, you’ve probably noticed we embrace evidence-based investing. But what does that mean?
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 related risk exposures, according to the most robust evidence available. This also means sticking with your long-view, evidence-based strategy once it’s in place, despite the market’s uncertainties and your own self-doubts you’ll encounter along the way.
Evidence-Based Investing, Applied
Do you hope …
- 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 …
- 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?
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 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?
Putting Back-Testing to Work for the Evidence-Based Investor
One invaluable tool in our evidence-based toolkit is the use of back-testing—analyzing historic market data to see how various investment portfolios would have performed under real-world conditions of the past. By running these scenario analyses, we can stress-test different combinations of assets through booms, busts, and everything in between, using decades’ worth of data.
Why does this matter? Instead of relying on wishful thinking or gut instinct, we can examine how certain risk/return profiles have actually played out. Back-testing helps us estimate whether a portfolio is robust enough to weather troubled markets, while also aiming for the returns you seek. Of course, no historical data can perfectly predict the future, but a strong, time-tested track record gives us a much sturdier foundation than the market’s latest hunch, optimizing for long-term outcomes and mitigating avoidable risks.
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 “torture” 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:
Understanding Value Stocks and Their Potential Premium
Let’s start with value stocks—a term that often pops up when discussing evidence-based investment strategies. So, what exactly are value stocks, and why do they sometimes seem to punch above their weight in terms of returns?
In essence, value stocks are shares of companies that appear to be trading for less than their intrinsic worth. This “hidden value” might be measured by looking at fundamentals such as a company’s assets, earnings, or projected cash flows. Think of it as shopping a clearance sale: you’re purchasing solid merchandise at a price below what it ought to fetch on a typical day.
Now, why would anyone expect a premium for holding these stocks? Here’s where robust, long-term academic research (the kind favored by thinkers like Eugene Fama and Kenneth French) comes in. Over extended periods and diverse markets, data reveal that investors in value stocks have historically earned higher average returns than those holding broad market portfolios. This is sometimes referred to as the “value premium.”
However, just as with any investment, there’s a catch. This advantage isn’t a free lunch. Value stocks can remain out of favor for years or face business challenges that justify their low price. Market sentiment or difficult industry shifts can delay—or sometimes prevent—their prices from converging with what their fundamentals might suggest.
Still, the evidence indicates that, over time and across many market cycles, investors willing to shoulder the risks associated with value stocks have often been rewarded with a little extra return relative to the market as a whole. That’s the tradeoff: greater expected reward, but with an extra helping of uncertainty along the way.
What’s in an Evidence-Based Name?
Last but not least, it’s worth mentioning, 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. That’s where we come in, to structure the right mix for you, and help you navigate through the ever-distracting informational overload. To learn more, let’s talk!