Evidence-based investing integrates a similar methodology as the more widely known evidence-based medicine, which incorporates broadly accepted research with sound design to optimize the decision-making thought process for the best outcome for the patient. The Centre for Evidence-Based Medicine at Oxford in the United Kingdom has high praise for the process, noting that, “Evidence-Based Medicine is the conscientious, explicit, and judicious use of current best evidence in making decisions about the care of individual patients.” Evidence-based investing (EBI) is not in theory too dissimilar from the evidence-based medicine process.
Simply stated, EBI makes use of the best evidence currently available for the initial design and implementation of an investment portfolio as well as for subsequent ongoing management of that portfolio. Compared to the normal methodologies, EBI could be a huge and beneficial change to an individual’s investing strategy.
The concept behind EBI comes from lauded professors and scholars from around the world, including Myron Scholes, Harry Markowitz, Robert C. Merton, William F. Sharpe, Eugene Fama and Merton Miller, all of whom are Nobel Prize laureates; Kenneth R. French rounds out the list.
A Look Back at Investing Through History
Taking a brief look at the history of investing should shed some light on the significance of EBI.
Investing began in the simplest form, with an individual’s purchase of land for farming for personal use. That was followed with an investment in one’s own business. In those two examples, an individual’s investment was generally of a personal nature, i.e. in himself or herself. That followed with investing in other individuals’ businesses or companies by buying a “share” of their livelihood. Buying stocks in this way also offered another benefit: diversification. Finally, with the purchase of bonds, which is essentially the debt of a business or company, an investor could, for all intents and purposes, loan money to that business.
Later, an investor might hire a broker-dealer, whose job is to make recommendations on suitable investment opportunities. The broker-dealer would also help complete the transaction which, more often than not, would earn him a commission.
Years later came the development of mutual funds. Which stocks or bonds go into the mutual fund is decided by the fund manager. Using his or her expertise and knowledge, the manager will make the final choice as to which companies will be included, and in what proportion. The fund manager will also occasionally rebalance the fund when it is deemed necessary. (For related reading, see: A Brief History of the Mutual Fund.)
Generally, broker-dealers are quite fond of mutual funds because someone else (i.e. the fund manager) has already done all of the homework. And the fact that they often result in a hefty commission (for the broker-dealer, of course) makes them that much more attractive. Many broker-dealers have decided to get a bigger piece of the action by creating their own “family" of mutual funds, which means not only do they earn a commission when they sell the mutual fund to an investor, they also get some of the management fee.
Ultimately, a fund manager’s goal was to beat the market. They attempted to do that with frequent buying and/or selling of the shares or bonds within the mutual fund, often based on the predictions of so-called industry experts. While that worked out nicely for the fund manager and for the broker-dealer, it meant higher fees for the investor. Often it wasn’t very tax-efficient for the investor. It has since been determined that an active management style hardly ever beats the market, even over time; however, it did make a very nice profit for some financial services companies. (For related reading, see: Fund Management Issues: Passive vs. Active Management.)
All of that eventually led to the development of index funds. In brief, an index fund contains stocks from a particular index (the Dow Jones Industrial Average (DJIA) is a good example) in a pre-determined percentage. One of the more well-known developers of index funds is Vanguard.
The Shortcomings of Conventional Investing
Let’s take a look at some of conventional investing’s shortcomings:
- Generally, active money management doesn’t outperform the benchmarks, even over long periods (and despite assertions to the contrary).
- Financial services companies tend to design and sell high-priced products.
- Those products, quite often, result in a conflict of interest.
- The resultant higher fees for the investor will negatively impact a portfolio’s performance.
- An investor should never rely on past performance when choosing a money manager.
- Timing the market hardly ever works. (For related reading, see: Market Timing Fails as a Money Maker.)
- Investors may make decisions that are behavior-based, generally to their detriment.
In a nutshell, the foregoing is essentially how “conventional investing” is viewed. Most financial services companies invest “conventionally” and are governed by the “suitability standard.” Simply put, their interests are often placed well ahead of yours! Evidence-based investing provides a better approach for the investor.
Why Evidence-Based Investing Works
Now, let’s look at why evidence-based investing works:
- The asset allocation within a portfolio should be determined by an investor’s specific goals and timeframes, and influenced by his or her risk tolerance and capacity.
- An investment portfolio should be diversified. That means the portfolio should contain stocks and bonds (both domestic and international), as well as REITs and/or cash equivalents.
- A portfolio that is tax efficient can boost returns.
- Low-cost investing can result in higher returns.
- For the risks taken, small-cap stocks can increase returns compared to large-cap stocks. (For related reading, see: An Introduction to Small-Cap Stocks.)
- Value stocks can offer premium returns over time compared to growth.
- Evidence has shown that passive management outperforms active management.
- Under the fiduciary rule, an investor’s interests would be maximized, as opposed to the suitability rule.
The evidence-based concept, as you might expect, is not well liked by the heavy hitters among the financial services companies (Merrill Lynch and Morgan Stanley, for example) or insurance companies and those firms that sell a product. Moreover, it isn’t embraced by advertisers or touted by “investment gurus” like Jim Cramer (among others). Why? Because EBI isn’t profitable for them.
But, it could well be profitable for you if you consider modifying your investing approach from the conventional methodologies to evidence-based. How do you start? With a financial advisor who incorporates EBI.
For more from this author, see: Questions to Ask Before Starting a Donor-Advised Fund.)