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Google “investment strategies” and prepare to be overwhelmed. You will be bombarded with a litany of choices provided to you by blogs, eBooks, brokerage firms, financial advisors, universities, paid subscriptions and newsletters, and ads. Some of it is sound advice, and some is not. It’s true information overload.
Many investors embark on an often fruitless journey in an attempt to find their “perfect” investment strategy, and it’s no wonder with so many options to choose from. However, as markets vacillate and analysts call for the next bull or bear market, they find themselves hopping from one strategy to the next, one investment to the next, or frozen with fear and sitting on the sidelines. For others, however, it’s an easier process because they ask themselves one simple question: What does the evidence suggest I should do?
Those who ask that simple question happen upon the principles of “evidence-based investing.” Together we’ll study its history and its merits, but first, this is not a how-to guide on evidence-based investing. The purpose of this article is to inform you about approaches to investing that are based on historical data, or evidence, and not based on speculation or opinions. It will be up to you to decide how to apply this information to your own investing, if at all.
What is Evidence-Based Investing?
As long-term investors, our goal is often to maximize our returns for a given level of risk we are willing to assume. Evidence-based investors do the same, but they utilize a systematic approach, one that relies on research findings and historical data to guide investment decisions. They don’t rely on hunches, rumors, emotions, or newsfeeds to make investment decisions, nor do they rely on so-called “expert” opinions. It also means remaining committed to a long-term strategy, despite market volatility or any doubt one might encounter along the way. This approach ensures that your investment decisions are grounded in sound research and analysis, reducing the likelihood of impulsive decisions driven by emotions or market noise – something many investors succumb to.
What Strategy Do You Practice?
Do you try to outsmart the market by buying and selling “mispriced” securities at just the right moment, and jump in and out of the market based on the latest economic reports and news? Or do you accept that the seemingly random up-and-down movements of the markets are too difficult to predict, and instead focus on designing an “all-weather” portfolio based on your investor profile?
The evidence supporting the second belief is overwhelming and goes back to at least 1952 when Harry Markowitz published “Portfolio Selection” in The Journal of Finance. Markowitz’s work became known as Modern Portfolio Theory (MPT) and other academics and industry practitioners have been expanding upon it ever since.
The Evidence
After dissecting a veritable mountain of data, the initial research and subsequent discoveries provided compelling evidence for two main points:
Investors should focus on long-term outcomes and disregard short-term news and events (aka “noise”). Put another way, investors shouldn’t base their long-term investment decisions on short-term headlines and news, which can’t reliably predict market movements in the short, intermediate, or long term.
Certain factors in portfolio construction (diversification) and management were better at enhancing performance and reducing risk compared to the common methods employed at the time, where “risk management” and diversification simply meant trying to buy the next “winner” and sell the next “loser” (aka “market timing”).
After the proverbial dust had settled, the evidence compiled suggested a long-term investor adopt the following principles:
Ignore short-term “noise” in the markets and take a long-term approach.
Understand that market timing will lead to diminished returns over the long run.
Minimize risks by building a globally diversified portfolio.
Reduce unnecessary costs that weigh on portfolio performance.
Avoid excessive trading as it will reduce overall returns.
Build portfolios based on your risk/return profile and investment time horizon.
Earn a long-term return that is commensurate with your investment goals and risk tolerance.
Control damaging behavioral biases and eliminate emotion-fueled decisions.
In essence, since we can’t control what the financial markets are going to do, nor can we predict what they’re going to do, let’s focus on the things we actually can control – our emotions and portfolio construction. And, as it turns out, by ditching the crystal ball and focusing on diversification, we can earn a higher risk-adjusted rate of return over the long run.
Expanding on this further, the evidence revealed that certain portfolio characteristics, or “factors”, can help investors enhance the risk/return relationship of the portfolio. By mixing and matching the following factors, investors can build robust portfolios, and alter the risk/return profile of their portfolio to suit their individual investment goals and risk tolerance:
Security Type: The allocation of stocks versus bonds
Market Cap: Large company stocks versus small company stocks
Valuation: Value versus Growth stocks
Profitability: Companies with high earnings versus low earnings
Momentum: Stocks in uptrends versus downtrends
Bond Maturity: Long-term bonds versus short-term bonds
Credit Quality: Investment grade bonds versus high-yield bonds
By pushing and pulling on various levers, investors can enhance, or optimize, portfolio return on a risk-adjusted basis, and the portfolio can be designed around an investor’s goals and objectives; a far cry from the stockbroker days of buying and selling a mix of stocks based on news, “tips”, and hunches. Investors could now use actual data, or evidence, as a basis for their investment decisions and portfolio construction.
How Do You Know What Evidence to Believe?
Almost every sales pitch for an investment or strategy can be backed by “evidence,” so how do you know what advice to heed? Data can be “mined” or “cherry-picked” to depict the outcome we want, and fund companies and certain asset managers are all too aware of this. You might be lured in by a fund or asset manager touting that they outperformed the S&P 500 index over the past 12 months, or during the last bear market, but how does that information benefit you when you’re trying to develop a long-term portfolio, one that needs to weather the ups and downs of the markets over the next 30 years?
Transform Information Into Knowledge
Facts and figures are important. We need that data as the basis for our decision-making process, but we must filter through the noise to find data that is truly useful in our quest for long-term success. The fundamental ingredient for separating fact from fiction, and for making evidence-based decisions, is academic rigor. This process needs to be:
Robust: The data set must be large enough so that it provides a thorough representation of the universe of data.
Unbiased: The outcome of the data shouldn’t represent a conflict of interest, so there is no incentive to produce a certain outcome.
Consistent: If new studies were reproduced with the same methodology but different data points, would the results be consistent?
Peer-Reviewed: The study should be published in credible, peer-reviewed forums where knowledgeable experts can comment on the data, methodologies used, and results.
Lastly, we must move from theory to practice. The common adage in the investment world is “past performance is no guarantee of future results,” so we must apply these results to the real world to determine if our theories can play out in real-time.
The Outcome
The principles outlined by Professor Markowitz and others have been tested, scrutinized, pushed, pulled, and tugged in every direction, in theory and in practice, through numerous economic regimes, and they have stood the test of time (for more than 70 years). In short, the principles have stood up to academic rigor AND the markets. Of course, there are always going to be critics, but it’s important to gauge whether those critics are offering an unbiased critique, or if they might have a conflict of interest (i.e., maybe they are selling a different, higher-cost strategy or investment), so make sure you’re diligent in your research.
In today's fast-paced and ever-changing financial landscape, making investment decisions can feel overwhelming. We live in a world of information overload and countless opinions on what works best, which feeds uncertainty. Evidence-based investing offers a compelling approach to navigating the complexities of the financial markets by relying on a system, or set of rules, based on decades of research and historical data, not speculation. However, it's important to note that evidence-based investing is not a magic bullet, and we know that past performance is not a guarantee of future results.
Your portfolio should be based on your financial goals, and your risk tolerance, so determine what strategy and investments are best suited for your unique situation. Do your research and determine the best path forward, for you, and if you are unsure of how to proceed, talk to a financial professional who can help you make informed decisions.
Tad Jakes, CFP®, EA