Evidence-Based Investing (“EBI”) is not a topic that is well known to many investors. And of those who have heard of it, only a few understand it.
EBI is patterned along the lines of Evidence-Based Medicine, which is designed to optimize decision-making for patient care. Stressing the use of evidence from well-designed and accepted research has shown to lead to a better patient outcome.
According to the Centre for Evidence-Based Medicine at the UK’s University of Oxford, “Evidence-Based Medicine is the conscientious, explicit, and judicious use of current best evidence in making decisions about the care of individual patients.” That approach to informed decision-making has spread to other fields, such as investing.
EBI is then the conscientious, explicit, and judicious use of current best evidence in making decisions about the implementation and management of an investor’s portfolio. This would be a major change for many investors who have been using a conventional investing methodology.
Why is this important? Perhaps reviewing the history of investing will provide a broader perspective.
The History of Investing
The first instance of investing was the purchase of land, which was farmed for personal use. Later, it was investing in your own small business. Put another way, you were investing in yourself. Later, with stocks, investing allowed diversification by buying into an ownership position of other person’s business. Or with bonds, investing was done by loaning others money by purchasing their debt.
In order to better know which stock or bond to buy, an investor would go to a “broker-dealer.” The broker-dealer would provide a recommendation and then complete the transaction, of course, for a commission.
In time, mutual funds were developed, where the fund manager would decide (based on his or her “expertise”) what to buy and sell within the mutual fund. Since their inception, broker-dealers have loved the concept of the mutual funds. They require only a little bit of homework on the part of the sales person (since the fund manager already did most of it) and they generally drew a big commission. In fact, many broker-dealers started their own mutual funds. In this way, they not only received the commissions on the sale but they also captured a share of the management fee, as well.
The strategy of the mutual fund managers was to buy and sell stocks and bonds with some frequency to “beat the market.” This approach often caused high trading costs, was not tax efficient and was expensive due to the hiring of “experts” to predict what to buy and sell. This active management style seldom beat their benchmarks over time but it did allow many financial services companies to get rich.
The “under performance of the benchmarks” and associated high costs led to the development of index funds, most notably by Vanguard. An index fund holds the stock of those companies listed within that index and in their predetermined percentage.
For example, the Dow Jones Index Fund would hold the 30 stocks that comprise the Dow Jones Industrial Average and in the percentage as indicated by the index. These index funds were not designed to beat the market but rather to capture the returns that the market provided while keeping costs low.
While index funds are good, there are some specific shortcomings. The biggest problem occurs when the index is reconfigured. Then, all of the financial services companies that offer that specific index fund will have to sell the same stocks on the same day and then they must all buy the same incoming stock. That results in a depressed stock price (of the stock sold) and an inflated stock price (of the stock bought), which may or may not be warranted.
The above snapshot would be described as “conventional investing.” Most financial services companies and their employees operate under this approach and are governed by the “suitability standard.” This allows the companies to put their interests (i.e. their products and associated fees) ahead of what is really in your best interest.
There is a better way than the conventional approach and it is EBI!
To start, we know what does not work well with conventional investing:
- •The vast majority of active money management fails to out-perform benchmarks over long time frames.
- •Financial services companies are good at designing and selling high priced products that are often subject to conflicts of interests under the suitability rules.
- •Higher investment fees negatively impact performance.
- •Past performance is not a good method for selecting a money manager.
- •Market timing seldom works, over time.
- •When it comes to investing, investors tend to make behavioral-based decisions and, quite often, mistakes
The well-founded evidence which we know does work includes:
- •Your portfolio’s asset allocation should be based on your investing goals, timeframe and influenced by your risk tolerance and risk capacity.
- •Your portfolio should be highly diverse, containing stock (US and non-US), bonds, REIT’s and cash equivalents.
- •Tax efficiency helps boost portfolio returns.
- •Low cost investing leads to higher returns.
- •Small stocks add greater return, over time, for the risk taken.
- •Value stocks offer a return premium, as well, over time.
- •Passive fund management out-performs active management, over time.
- •As an investor seeking advice, your interests are better served under the Fiduciary Rule rather than the suitability rule, which is common with conventional investing.
This “Best Evidence” for proper investing emanates from academia and professors such as Harry Markowitz* at City University, New York, Myron Scholes* and William F. Sharpe* at Stanford, Robert C Merton* of MIT and Harvard, Merton Miller* and Eugene Fama* of the University of Chicago, Kenneth French of Dartmouth College, as well as others. (* designates the Nobel Prize in Economics)
As you might expect, the concept of “Best Evidence” is not one disseminated by the financial services companies such Merrill Lynch, Morgan Stanley or Fidelity. Nor does it come from insurance companies or others that sell a product.
“Best Evidence” is also not a topic found in articles published by Money Magazine or Kiplinger’s. And it won’t come in the form of advice from television’s Jim Cramer or any of his kind. Of course not; those are all intended to maximize advertising dollars and “Best Evidence” simply does not bring in advertising money.
If you want to improve your outcome when investing for a successful future, you may need to change your investing approach. Switch from the conventional investing methodology (often filled with conflicts of interest) to one that is truly in your best interest, the Evidence-Based Investing approach!