Tag Archives: evidence-based investing

Justwealth: The advantages of Evidence-based Investing

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One of the most important developments in the financial world in recent years has been the growth of evidence-based investing. But what exactly is it? In the first of a new series of exclusive articles for Justwealth, the UK based author and journalist Robin Powell explains why founding your investment strategy on four basic principles can dramatically improve your chances of achieving your long-term goals.

By Robin Powell, The Evidence-Based Investor 

Special to Financial Independence Hub

It takes between seven and nine years to train to be a doctor in Canada. For surgeons it takes as many as 14. Even then, both doctors and surgeons are required to engage in continuous learning throughout their careers.

Becoming a financial adviser, investment consultant or money manager is considerably less onerous. What’s more, unless you deliberately set out to defraud your clients, you’re unlikely to be stripped of your right to operate.

Of course, there are still examples of poor medical practice. It was only as recently as the early 1990s that a group of epidemiologists at McMaster University in Hamilton, Ontario, first coined the phrase evidence-based medicine. Sadly, though, professional malpractice in the investing industry is far more common, and there are many who have worked in it for decades and yet act as if they have little or no grasp of the evidence on how investing works.

A glaring illustration of this is a study published in May 2018 called The Misguided Belief of Financial Advisers. The researchers analyzed the returns achieved by around 4,400 advisers across Canada: both for their clients and for themselves. They found that the advisers made the same mistakes investing their own money as they did when investing their clients’ money.

For example, they traded too frequently, chased returns, preferred expensive, actively managed funds, and weren’t sufficiently diversified. All of those things have been shown, time and again, to lead to lower returns. On average, the clients of the advisers analyzed underperformed the market by around three per cent a year: a huge margin.

What is evidence-based investing?

In recent years, we’ve seen the development of what’s called evidence-based investing (EBI). Like evidence-based medicine, it entails the ongoing critical appraisal of evidence, rather than relying on traditional practices or expert opinions.

So what sort of evidence are we talking about? Essentially there are four main elements to the evidence that underpins EBI.

First, the evidence is based on research that is genuinely independent; in other words, the research wasn’t paid for or subsidized by organizations with a vested interest in the outcome.

Secondly, it’s peer-reviewed. This means that the findings are published in a peer-reviewed journal which is closely examined by experts on the subject.

Thirdly, the evidence is time-tested. Investment strategies often succeed over short time periods, but fail over longer ones. Investors should disregard any evidence that hasn’t stood the test of time.

Finally, the evidence results from rigorous data analysis. As everyone knows, data can be very misleading if it hasn’t been properly analysed.

The good news is that, even when all four of these filters are strictly applied, there is still plenty of evidence to inform our investment decisions. Since the 1950s, finance departments at universities across the globe have produced many thousands of relevant studies.

What does the evidence tell us?

What, then, are the main lessons from academic research on investing? This is a wide-ranging subject, and one we’ll look at in more detail in future articles, but there are four main takeaways.

Markets are broadly efficient

Because markets are competitive and prices reflect all knowable information, it’s very hard to identify stocks, bonds or entire asset classes which are either undervalued or overvalued at any one time. No, prices aren’t perfect, but they’re the most reliable guide we have as to how much a security is worth.

Diversification is an investor’s friend

It’s vital for investors to diversify across different asset classes, economic sectors and regions of the world. As well as reducing your risk, diversification can also improve your returns in the long run, and it is rightly referred to as “the only free lunch in investing.”

Costs make a big difference

The investing industry and the media tend to focus on investment performance. But while performance comes and goes, fees and charges never falter. Continue Reading…

An Evidence-based guide to investing

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What’s the point of investing, anyway? We invest our money for future consumption, with the idea that we’ll earn a higher rate of return from investing in a portfolio of stocks and bonds than we will from holding cash.

But where does this equity premium come from? And how do we capture it without taking on more risk than is needed? Moreover, how do we control our natural instincts of fear, greed, and regret so that we can stay invested long enough to achieve our expected rate of return?

For decades, regular investors have put their trust in the expertise of stockbrokers and advisors to build a portfolio of stocks and bonds. In the 1990s, mutual funds became the investment vehicle of choice to build a portfolio. Both of these approaches were expensive and relied on active management to select investments and time the market.

At the same time, a growing body of evidence suggested that stock markets were largely efficient, with all of the known information for stocks already reflected in their prices. Since markets collect the knowledge of all investors around the world, it’s difficult for any one investor to have an advantage over the rest.

The evidence also showed how risk and return are intertwined. In most cases, the greater the risk, the higher the reward (over the long-term). This is the essence of the equity-risk premium – the excess return earned from investing in stocks over a “risk-free” rate (treasury bills).

Evidence-based investing also highlights the benefit of diversification. Since it’s nearly impossible to predict which asset class will outperform in the short-term, investors should diversify across all asset classes and regions to reduce risk and increase long-term returns.

As low-cost investing alternatives emerged, such as exchange-traded funds (ETFs) that passively track the market, the evidence shows that fees play a significant role in determining future outcomes. Further evidence shows that fees are the best predictor of future returns, with the lowest fees leading to the highest returns over the long term.

Finally, it’s impossible to correctly and consistently predict the short-term ups and downs of the market. Stock markets can be volatile in the short term but have a long history of increasing in value over time. The evidence shows staying invested, even during market downturns, leads to the best long-term investment outcomes.

Evidence-based Guide to Investing

So, what factors impact successful investing outcomes? This evidence based investing guide will reinforce the concepts discussed above, while addressing the real-life burning questions that investors face throughout their investing journey.

Questions like, should you passively accept market returns or take a more active role with your investments, should you invest a lump sum immediately or dollar cost average over time, should you invest when markets are at all-time highs, should you use leverage to invest, and how much home country bias is enough?

To answer these questions, I looked at the latest research on investing and what variables or factors can impact successful outcomes. Here’s what I found:

Passive vs. Active Investing

The thought of investing often evokes images of the world’s greatest investors, such as Warren Buffett, Benjamin Graham, Peter Lynch, and Ray Dalio: skilled money managers who used their expertise to beat the stock market and make themselves and their clients extraordinarily wealthy.

But one man who arguably did more for regular investors than anyone else is the late Jack Bogle, who founded the Vanguard Group. He pioneered the first index fund, and championed low-cost passive investing decades before it became mainstream.

Jack Bogle’s investing philosophy was to capture market returns by investing in low-cost, broadly diversified, passively-managed index funds.

“Passive investing” is based on the efficient market hypothesis: that share prices reflect all known information. Stocks always trade at their fair market value, making it difficult for any one investor to gain an edge over the collective market.

Passive investors accept this theory and attempt to capture the returns of all stocks by owning them “passively” through an index-tracking mutual fund or ETF. This approach avoids trying to pick winning stocks, and instead owns the market as a whole in order to collect the equity risk premium.

The equity risk premium explains how investors are rewarded for taking on higher risk. More specifically, it’s the difference between the expected returns earned by investors when they invest in the stock market over an investment with zero risk, like government bonds.

Bogle’s first index fund – the Vanguard 500 – was founded in 1976. At the time, Bogle was almost laughed out of business, but nearly 50 years later, Vanguard is one of the largest and most respected investment firms in the world. Who’s laughing now?

In contrast, opponents of the efficient market hypothesis believe it is possible to beat the market and that share prices are not always representative of their fair market value. Active investors believe they can exploit these price anomalies, which can be observed when trends or momentum send certain stocks well above or below their fundamental value. Think of the tech bubble in the late 1990s when obscure internet stocks soared in value, or the 2008 great financial crisis when bank stocks got obliterated.

Comparing passive vs. active investing

Spoiler alert: there is considerable academic and empirical evidence spanning 70 years to support the theory that passive investing outperforms active investing.

The origins of passive investing dates back to the 1950s when economist Harry Markowitz developed Modern Portfolio Theory. Markowitz argued that it’s possible for investors to design a portfolio that maximizes returns by taking an optimal amount of risk. By holding many securities and asset classes, investors could diversify away any risk associated with individual securities. Modern Portfolio Theory first introduced the concept of risk-adjusted returns.

In the 1960s, Eugene Fama developed the Efficient Market Hypothesis, which argued that investors cannot beat the market over the long run because stock prices reflect all available information, and no one has a competitive information advantage. Continue Reading…

Timeless Financial Tips #5: Trust the Evidence

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Evidence-Based Investing – Your Best Chance to Hit Your Long-Term Investment Goals

By Steve Lowrie, CFA

Special to Financial Independence Hub

If I could, I would grant amazing investment returns to every investor across every market. Unfortunately, that’s just not how it works. In real life, we must aim toward our financial ideals, knowing we won’t hit the bullseye every time.

That’s why I recommend evidence-based investing: or investing according to our best understanding of how markets have actually delivered available returns over time, versus how we wish they would. Our “best understanding” may still be imperfect, but it sure beats ignoring reality entirely.

Luck-Based Investing and Random Returns

Many investors try to pick and choose when and how to invest based on what they or others are predicting will happen next. All evidence suggests their success or failure will be driven far more by luck than skill. Worse, going down this path, there is a very high probability they’ll end up with worse results versus a properly structured “buy and hold” approach.

Some deliberately embrace this approach, hoping to “beat” the market. Others come to it accidentally, by reacting to financial behavioural biases such as panic-selling or spree-buying. Either way, these sorts of investment portfolios typically devolve into a disheartening assortment of holdings over time, offering little sense of where you stand in relation to your own goals or overall market performance. The odds stack steeply against your achieving any carefully planned outcome: provided you had one to begin with.

Evidence-Based Investing and Portfolio Planning

In contrast, evidence-based investors adhere to decades and volumes of time-tested, peer-reviewed analysis by academics and practitioners alike. In aggregate, we seek to answer an essential investment challenge:

How can an investor increase the probability they’ll capture the highest expected market returns, given the levels of investment risk they’re willing to accept?

The answers point to a two-step strategy:

1. Build It. Prepare your personal portfolio:

  • Allocate your investments between broad asset classes.
  • Widely diversify your bonds and equities to reduce the unnecessary risks inherent to individual bond or stock picks.
  • Tilt your overall portfolio toward factors with higher expected returns, according to your personal financial goals and risk tolerances.

2. Keep It. Sit tight with your carefully constructed portfolio for the long term, to ensure you capture the expected long-term growth from your various market allocations. So, stay invested through thick and thin and set aside enough cash reserves to cover upcoming spending needs.

At the risk of repeating ourselves (which is, after all, the theme of this “Play It Again, Steve” financial tips blog series), evidence-based investing translates into building and maintaining a portfolio that looks something like this:

three key portfolio construction decisions

Keeping It: The Hardest Thing

It’s one thing to build an ideal portfolio. It’s another to keep it in balance as intended. In fact, thanks to our behavioural biases, I would argue it’s the hardest part.

For example, what will you do after the stock market has been surging, and your 60%/40% stock/bond allocations end up being closer to 70%/ 30%.? You’ll probably want to let your overweight allocation to high-flying stocks ride, hoping to score even more. That’s because recency and other behavioural biases trick us into believing the party will never end. However, the more prudent, evidence-based move is to sell some of your equity allocations (selling high) and use the proceeds to buy more humdrum fixed income (buying low), until you’re back to your original 60%/40% mix. Continue Reading…

Avoiding the “big mistake” — How Evidence-based investing saves long-term wealth

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By Steve Lowrie, CFA
Special to the Financial Independence Hub
“Buy low, sell high.”

Sure, it’s a tired cliché, but it’s actually good advice.  Everyone knows it.  Most of us may even manage to do it by simply leaving well enough alone instead of constantly questioning our investments.  This is especially so if you’ve preceded your inactivity by setting up a solid plan and investing accordingly.

But here’s the challenge: Even the most stay-put investor is still at risk for making that rare “big mistake.”  It happens when seemingly game-changing news tricks you into falling for a different financial platitude: This time is different.

Even if you only deviate from your routine in the face of an extreme event, the financial damage done can last a lifetime.  One of the biggest, most recent anomalies was the Financial Crisis of 2008/2009.  At the time, many investors (and many advisors as well) wondered whether the markets would ever recover.

Although we are almost 10 years removed from this time, it was a highly emotional period for investors.  In fact, one of my favourite financial commentators — Nick Murray — refers to this period as The Great Panic. To put this into context, let me share a few real-life investor anecdotes.

Take “Joe,” for example, who reached out to me to inquire about my services in October 2008.  At the time, Joe had a $2.6 million portfolio.  He had a very stable and successful business and wasn’t planning to tap into his investments for a couple of decades.  His portfolio wasn’t perfect.  Some of his holdings had high expense ratios, and some of them could have been better managed.  But overall, they seemed relatively well diversified and well structured.  He was doing okay.

Still, Joe was thinking about abandoning his balanced approach and moving to cash.  I offered Joe this timeless advice:  When we’re in the thick of a bear market, nobody knows when or how it might reverse course.  But we do know it is highly likely it eventually will: often quickly and without warning.  If you try to time when to be in and out of the market for optimal effect, you must not only correctly guess when to get out, you’ve also got to predict exactly when to get back in.

Cashing out in 2008

So, November 2008 came and, along with it, a second major market drop. This was too much for Joe.  In late November, he called me and told me something like this:  “Thanks for your time.  However, this time really is different, and your history and evidence doesn’t matter.  I have sold my entire portfolio and moved all my investments into cash.”

I don’t know what happened to Joe after that, because we went our separate ways.  In the short run, he was right.  We didn’t know it then, but the third (and final) major drop in the equity markets arrived in January/February 2009.  Using historical index data and assuming a balanced portfolio of 60% Global Equities and 40% Global Bonds, liquidating his portfolio ahead of this final drop “saved” him from a loss in the range of $200,000.

Once again, using index data, had he simply held his portfolio he would have made back the “$200,000 loss” by May/June 2009 and then been almost 20% higher by November 2009.  In dollar terms, that is over $500,000 higher than he was in November 2008.

I doubt Joe had the nerve to reinvest anytime in 2009 …  it’s far more likely he waited until the recovery was in full swing, buying higher than necessary and sacrificing returns that could have been his by simply holding tight.  Or, for all I know, he’s still sitting in cash today.  If so, he has so far given up about $3 million in potential wealth … even after assuming reasonable fees for investment management, financial planning, and (most importantly in Joe’s case) behaviourial coaching. Continue Reading…