At Vickery Financial, we throw the phrase “evidence-based investing” (or “EBI” for short) around fairly casually, without spending much time to actually define it. This month, I’d like to explain to our readers outside of the finance industry exactly what we mean by EBI and why we believe it offers the best path for a successful investment experience.
It is important to stress that EBI is one of many investment philosophies – a way to interpret and understand financial markets and the behavior of investors that participate in them. Other investment philosophies might focus on short-term price movements, high-frequency trading, the fundamental values of public corporations (i.e. “stock picking”), or even attempt to speculate on particular corporate events such as mergers. Evidence-based investing stands in stark contrast to these other philosophies, and in order to fully understand it, we must go back to its origins.
Beginning in the 1950’s, academic researchers began to apply scientific methods to the study of finance and markets. Over the course of the next several decades, thousands of peer-reviewed articles on this subject were vigorously debated, revised, re-written, sometimes abandoned, debated again and ultimately published in academic journals. The standards for publication are extraordinarily high and go far beyond the cursory analysis, back-testing or “gut feel” that often passes for quality research by Wall Street or institutional money managers. The peer-reviewed academic method is quite simply how modern science is conducted – it is the highest intellectual standard we have yet devised, and is literally the way human knowledge advances.
From this enormous body of work, EBI was born, and today’s fortunate investors are able to benefit from this valuable research. But despite the sheer number of academic articles published, the core tenets of EBI are fairly easy to encapsulate, and investors need only be aware of a few key elements to improve their overall investment experience. They are:
- Creating ‘optimized’ portfolios (maximizing return for a given level of risk) which focuses primarily on the asset allocation decision, rather than on security selection
- Minimizing expenses through prodigious use of low-cost, low-turnover mutual funds
- Ensuring wide geographic, asset class and security diversification
- Tilting the portfolio toward a few known risk factors to enhance returns
- Accepting the behavioral biases that humans exhibit and forging a strategy to deal with them
- Having a regular and disciplined re-balancing strategy to maintain a target risk profile
Notice that there is no forecasting involved, nor any attempt to predict short-term market movements. The evidence is very clear on this point – individual investors tend to make poor market timing decisions that subtract from their net returns. This turns out to be one of the most reassuring features of EBI, as it demonstrates that these kinds of decisions are unnecessary, and even counter-productive to a successful investment experience. Rather, EBI is an investment philosophy that inherently trusts the market to deliver positive, inflation-beating returns. Instead of fighting the market, or trying to out-guess it, EBI shows us that we really just need to participate in it.