Evidence-based approach can take the guesswork out of investing
Many would argue all investment decisions are based on certain bodies of evidence, but we should focus on those that are peer-reviewed, time-tested and academic in nature
A few days ago I visited my physio with a middle-age sports injury. We started discussing the pros and cons of ultrasound. The physio, a consummate professional, immediately began to cite the publications and evidence for or against its use. It reminded me of where the medical profession stands relative to my own in investment management.
Mark Ebell, a professor at the University of Georgia, defines evidence-based medicine (EBM) as the “conscientious, explicit, and judicious use of current best evidence in making decisions about the care of individual patients”. I’d go along with this approach. You? I guess the alternative is a sort of “learned guess” or trial-and-error approach, which may yield results but may also go horribly wrong. Or perhaps in the SA context a visit to your local sangoma (but now I’m treading on dangerous ground).
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The question is, how much of the investment industry is premised on such an evidence-based approach — an approach supported by facts and research — and how much of it is learned guesswork? It’s not as if the stakes are any lower; financial health and physical health are two of life’s essential pursuits. While I have huge respect for the calibre of people in the investment industry, which attracts some of the finest minds, I challenge the humility of my peer group. All too often the focus is on having all the right answers on issues which, frankly, have little to do with the problem at hand.
The aim, remember, is to ensure families meet their financial goals. Investment managers should be more focused on the financial planning problem, which has less to do with the headlines dominating our news or having the answers as to how near-term events may or may not play out — these questions tend to be unanswerable. In our profession, many are guilty of making investment decisions based on predictions, rather than simply falling back on the tried-and-tested evidence that’s available in our field. At most investment conferences I attend there is plenty of bravado as to who has the right prediction, rather than a focus on the client and the client’s needs.
John Bogle, credited as the father of index fund investing, once quipped: “The mutual fund industry has been built, in a sense, on witchcraft.” A dig at those who believe they can make near-term predictions of markets, individual shares, interest rates and so on.
Evidence-based investing (EBI) is an investment approach that aims to follow the world of the modern medic, focusing on the longer-term investment outcomes of clients (near-term movements in equities, interest rates and currencies). It centres on answerable questions (what asset allocation makes sense given a certain time and risk tolerance? Or, what is the best way to structure my investments to create a required income stream?).
The term “evidence-based” has copped some criticism; many would argue all investment decisions are surely based on certain bodies of evidence (analyst reports, leading indicators). But we can’t process the conclusions derived from these sorts of forward-looking predictions with accuracy or consistency. We should focus on bodies of evidence that are peer-reviewed, time-tested and academic in nature.
To articulate the term EBI, financial blogger Phil Huber interviewed some thought leaders advocating the adoption of an evidence-based approach: Huber summarised the process into this quirky formula: EBI equals numbers over narratives, plus time over timing, plus process over predictions, plus humility over hubris, plus sleep over stress. “One thing I have learnt about EBI over the years is that it’s less a map telling you exactly where to go and how to get there and more an internal compass of investing principles that are supported by data, theory and common sense.”
So which pieces of evidence can we reliably use when investing? There are many, but perhaps four of the key elements are:
- Asset class returns characteristics: we have an excellent understanding of how asset classes are likely to reward through time and over different periods. We know, for instance, that a young person with a long time horizon should have a high risk tolerance and should be broadly exposed to equities. The specific types of stocks are less relevant — the evidence shows that stock-picking relative to the market is incredibly difficult — hence the focus on index funds.
- Diversification: described as “the only free lunch in investing”, it’s a mathematical truth that by holding uncorrellated assets and shares, we can expect the same level of returns, but at a lower level of risk.
- Costs: these are a structural drag on an investor’s returns. By keeping costs low we can improve returns — evidence shows that cost is one of the main predictors of future returns. Lower cost equals higher returns.
- Factors (smart beta): there is a significant body of evidence demonstrating that shares with certain risk attributes offer a risk-reward profile that is different from the general market. Though a more technical area of the asset management industry, evidence shows that exposure to these risks over time can generate higher investor returns. For example, evidence shows that over the long term, smaller companies outperform larger companies (the size factor).
Along with these elements comes a stronger focus on the behavioural aspects that often hold investors back from realising their investment goals. It is critical to stay invested and not chop and change your strategy.
• Stobie is CoreShares MD.