Cogent Essential Insights: What Is Evidence-Based Investing?
By Michael Evans, Founder & CEO of Cogent Strategic Wealth
How do you invest your money over the long-term? If you are a hard-driving professional like me, don’t you want your wealth to be as high-achieving as you are?
If you’ve read much of our work, you’ve probably noticed Cogent embraces evidence-based investing. Several reasons and important life lessons learned have led us to this critical decision.
A Cogent Discovery
My own epiphany happened in October 2001 when I became the lead plaintiff of a class action lawsuit after a negligent mutual fund manager cost me $244,000 of my hard-earned “safe money.” Although we prevailed in court, I vowed to never again let that happen to me or anyone else I cared for.
We all experience pain and loss in our lives. But I believe in turning missteps into learning moments by reflecting on how to avoid them moving forward. What I discovered was eye-opening: I looked at the evidence and saw that relying on active management, forecasts, market timing, and the latest investment guru’s advice was unlikely to lead to a good outcome. In fact, it was more likely to repeat the same mistakes I’d already made. No thanks!
Ignore the Evidence at Your Own Peril
A vast body of research has demonstrated, active managers are unlikely to deliver alpha (or persistent excess performance) beyond their appropriate, risk-adjusted benchmarks.
Once I knew about this extensive peer-reviewed, academic research, I stopped following the fads, and adopted an investment approach based on a belief in relative market efficiency. Rather than relying on futile forecasting or trying to outguess others, I started drawing on prudent finance theory about earning expected returns from the market itself—letting the collective knowledge of its millions of buyers and sellers set security prices.
Cogent’s investment approach is grounded in economic theory and backed by decades of empirical research. It means we take a less subjective, more systematic approach to investing. It’s an approach we can implement consistently, and that our clients can more readily understand and stick with, even in challenging market environments.
For 20 years, I have been an unapologetic “evidence-based investor.” Back in 2001, it was called “passive investing,” not because you sit back and let others mindlessly manage your money. Rather, you stop engaging in the fancy footwork associated with traditional active investing—chasing high yield or alpha without clearly understanding the costs and context.
To follow my journey in adopting evidence-based investing, see our blogs HERE and HERE.
Evidence-Based Investing, Applied
Next, let’s take a look at how we implement evidence-based investing.
What Is Evidence-Based Investing?
Evidence-based investors build and manage their portfolio based on what is expected to enhance future returns and/or dampen related risk exposures, according to the most robust evidence available. This also means sticking with your long-view, evidence-based strategy once it’s in place, despite the market uncertainties and self-doubts you’ll encounter along the way.
Do you believe investors can come out ahead by discovering mispriced stocks, bonds, and other trading opportunities; and/or by dodging in and out of rising and falling markets?
Or do you accept that the market’s short-term trading action creates relatively efficient pricing that is too random to predict? Does this lead you to take a long-view approach, build a unified investment portfolio, and focus on more manageable details, such as:
- Tilting toward or away from entire asset classes to tailor risks and expected returns
- Minimizing avoidable risks by diversifying globally
- Reducing costs
- Controlling your own damaging behavioral biases
There is an overwhelming body of evidence suggesting long-term investors should favor the latter approach and avoid the former one. This has been the case since at least 1952, when Harry Markowitz published Portfolio Selection in The Journal of Finance. “In Pursuit of the Perfect Portfolio” professors Andrew Lo and Stephen Foerster describe:
“While it’s commonplace now to think of creating a diversified portfolio rather than investing in a collection of securities that each on their own look promising, that wasn’t always the case. It was Harry Markowitz who provided a theory and a process to the notion of diversification. He helped to create the industry of portfolio management.”
Markowitz’s work became known as Modern Portfolio Theory (MPT). Academics and practitioners have been building on it ever since.
Evidence-Based Investment Factors
Which factors appear to best explain different outcomes among different portfolios? In what combinations are these factors expected to create the strongest, risk-adjusted portfolios? What explains each factor’s return-generating powers, and can we expect the explanation to persist?
Based on the academic answers to these practical questions, we typically mix and match the following factors in our evidence-based portfolios, varying specific exposures based on investors’ personal goals and risk tolerances:
1. & 2.
How Do You Decide Which Evidence To Heed?
So far, so good. Then again, at first blush, nearly every investment recommendation may seem “evidence-based.” After all, no forecaster would peer into an actual crystal ball when making their predictions. And no market guru would admit their stock-picking track record has been no better than a dart-throwing monkey’s (even though that’s usually the case).
Instead, stock-picking and market-timing enthusiasts tend to argue their cases by turning to articulate analyses, smart charts, and convincing corporate briefs to explain all the late-breaking news, and what investors should supposedly be doing about it.
Evidence-based investors do not try to outguess the market. The market’s pricing power works against mutual fund managers who try to outperform through stock picking or market timing. As evidence, only 19% of US equity mutual funds and 11% of fixed income funds have survived and outperformed their benchmarks over the past 20 years.
3. see below
In this chart, the light-gray bars represent the number of US-domiciled equity and fixed income funds in operation during the past 20 years. These funds compose the beginning universe of that period. The dark-gray areas show the percentage of equity and fixed income funds that survived the 20-year period. The blue and green bars show the much smaller percentage of equity and fixed income funds, respectively, that both survived and outperformed their respective benchmarks during the period.
Research shows that over both short and long time horizons, the deck is stacked against fund managers who attempt to outguess the market. As an investor, would you take those odds? We wouldn’t either.
Putting the Data into Evidence-Based Context
There’s nothing wrong with facts and figures. Many fund managers believe they can identify “mispriced” securities and convert that knowledge into higher returns. But fair market pricing works against such efforts, as indicated by the large proportion of mutual funds that have underperformed their benchmarks.
The critical difference is how we apply the data. As financial author Larry Swedroe describes it:
“In investing, there is a major difference between information and knowledge. Information is a fact, data or an opinion held by someone. Knowledge, on the other hand, is information that is of value.”
— Larry Swedroe, ETF.com
No matter how compelling a call to action may be, we discourage continuous reaction to the never-ending onslaught of information. First, we must determine: Which new information is just more of the same old noise, already factored into your evidence-based investment strategy? Which, on the other hand, might add value to our decisions by refuting or building on the enduring evidence?
The Evidence-Based Silver Bullet: Academic Rigor
When it comes to investing, there is a lot more noise than there is valuable knowledge. That’s why the basic recipe for evidence-based investing begins and ends with a key ingredient to help us separate likely fact from probable fiction: academic rigor.
What does academic rigor look like?
- It requires robust data sets that are large enough, representative enough, and free from other common data analysis flaws.
- Authors should be impartial, lacking incentives to “torture” the data to make a point.
- Others should be able to reproduce the same findings under different scenarios, suggesting the results are more likely to persist upon discovery.
- The data, methodology, and results should be published in reputable, peer-reviewed forums where informed colleagues can critique the findings.
- Enough time must pass to make all of the above possible.
After that, we also must be able to apply the results in the real world. So, even if a theoretical strategy is expected to enhance your returns, it must do so after considering all practical costs and portfolio-wide tradeoffs involved. For example, sometimes one source of expected returns negates another, even bigger source.
What’s in an Evidence-Based Name?
Last but not least, it’s worth mentioning, others may refer to the same or similar approaches by various names, such as factor-based, asset-based, or science-based investing. These terms are relatively interchangeable, but there’s a reason we’ve chosen evidence-based as our preferred term. Heeding sound reason and rational evidence is at the root of what we do. Therefore, we believe it should be at the root of what we call it.
When you choose an advisor, make sure they show you the research backing up their approach. If they hesitate or refuse, RUN! Feel free to ask us how we embrace evidence-based investing. We are all too willing to guide you through the research and what we strive to do for ourselves and our clients.
What would your best evidence-based investment portfolio look like? To find out, sit down with us today for a Cogent Conversation. We’ll listen to what success looks like for you, explore any challenges your family faces, suggest a portfolio tailored to you, and help you build and manage it every step of the way.
Don’t manage your family’s financial future all on your own. Book your Cogent Conversation today!
1. Relative price as measured by the price-to-book ratio; value stocks are those with lower price-to-book ratios.
2. Profitability is a measure of current profitability, based on information from individual companies’ income statements.
3. The sample includes funds at the beginning of the 20-year period ending December 31, 2020. Each fund is evaluated relative to its primary prospectus benchmark. Survivors are funds that had returns for every month in the sample period. Winners are funds that survived and outperformed their benchmark over the period. Where the full series of primary prospectus benchmark returns is unavailable, non-Dimensional funds are instead evaluated relative to their Morningstar category index. US-domiciled, non-Dimensional open-end mutual fund data provided by Morningstar. Equity fund sample includes the following Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Global Real Estate, Japan Stock, Large Blend, Large Growth, Large Value, Mid-Cap Blend, Mid-Cap Growth, Mid-Cap Value, Miscellaneous Region, Pacific/Asia ex-Japan Stock, Real Estate, Small Blend, Small Growth, Small Value, World Large Stock, and World Small/Mid Stock. Fixed income fund sample includes the following Morningstar historical categories: Corporate Bond, High Yield Bond, Inflation-Protected Bond, Intermediate Core Bond, Intermediate Core-Plus Bond, Intermediate Government, Long Government, Muni California Intermediate, Muni California Long, Muni Massachusetts, Muni Minnesota, Muni National Intermediate, Muni National Long, Muni National Short, Muni New Jersey, Muni New York Intermediate, Muni New York Long, Muni Ohio, Muni Pennsylvania, Muni Single State Intermediate, Muni Single State Long, Muni Single State Short, Muni Target Maturity, Short Government, Short-Term Bond, Target Maturity, Ultrashort Bond, World Bond, and World Bond-USD Hedged. See Dimensional’s Mutual Fund Landscape 2021 for more detail. Index data provided by Bloomberg, MSCI, Russell, FTSE Fixed Income LLC, and S&P Dow Jones Indices LLC. Bloomberg data provided by Bloomberg. MSCI data © MSCI 2021, all rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. FTSE fixed income indices © 2021 FTSE Fixed Income LLC. All rights reserved. S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment. Their performance does not reflect the expenses associated with management of an actual portfolio. There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results.
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