What You Need To Know about Evidence-Based Investing

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Image of magnifying glass and evidence bag for crime scene investigationThe title,  what you need to know about evidence-based investing, may sound a bit presumptuous.

And it probably is.

When I hear someone say to me “you need to know” at the beginning of a sentence, I'm likely to put up my guard.

Please bear with me.

There is so much noise out there around investing – claims, promises, products and the like – that I wanted to offer an alternative based on data.

You may not agree with the “evidence” I offer.

And that's OK.

However, I'm confident that by the end of the series, you will have learned something you may not have previously known.

So, if you can overlook the boldness of the title and digest the information I'm about to provide, I'm guessing you'll be glad you did.

A three-part series

I thought it best not to try to cover the evidence-based investment strategy in one article.

With that in mind, I decided to do a series of three articles.

Here's the plan:

Part one – In this article, I'll cover the basics of what's involved in an evidence-based investment strategy. That includes a discussion of active vs. passive management and the various elements of the stock portion of the approach.

Part two  – Here, I'll talk about the role fixed income has in an evidence-based investment strategy. What is a term premium? A credit premium? How much risk should you take in the bond portion of the portfolio? How much should you have in bonds in the first place?

Part three  – And finally, I'll show you how to construct a portfolio using the pieces from the first two parts. What kind of funds are best to use? ETFs? Mutual funds? Pure index funds? Non-indexed asset class funds? What role does rebalancing play?

With that background, let's continue with our initial discussion.


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Passive vs. active investing

Let me say out the outset.

An evidence-based investment strategy is one of many options available to investors.

In my experience, though, many investors don't follow any particular strategy.

Useful information is hard to come by when choosing how to invest. Much of it comes from the brokerage and insurance industry.

In general, they advocate for strategies that involve you using their products to implement them. That's a massive conflict of interest.

Pundits argue over whether active or passive investments are better all of the time.

I won't rehash that argument here.

Instead, I'll briefly explain what how each one works.

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Active investing

With active management, fund managers decide which stocks to buy, at what prices, in what industries, etc. The idea is that their stock-picking skill provides market-beating returns for investors.

Each fund offers a different type of active management. One fund might invest only in the largest companies. Another might invest in the smallest. Still, others might focus on a particular market sector like technology or financial companies.

The idea, though is that their stock picking and timing offer higher returns than passive investments.

Passive investing

Passive investing is often called index investing.

Managers of passive funds invest in all of the stocks (or bonds) in a particular index.

They two most recognizable stock indexes are the Dow Jones Industrial Index (DJIA) and the S & P 500 Index. When the question of “what did the market do today” gets asked, it's usually about one of these two indexes.

The DJIA represents just thirty companies. Typically they're among the thirty largest.

It's a price-weighted index (sorted by companies with the highest share price to the lowest among the thirty). Stocks in the index selling at the highest share prices have the most substantial impact on the index.

The S & P 500 represents the 500 largest companies in the U.S. by market capitalization. These stocks get sorted by the highest market value to the lowest. The largest companies have the most impact on the index.

Managers of these index funds do not consider industry, share price, or timing (except once a year when the index gets reconstituted).

That term is industry jargon that means that stocks that don't meet the index criteria get sold, and replaced by stocks that do.

They buy every company in the index based on either the size of the company (S&P 500) or by its share price (DJIA)

Related:
Protect Your Investments in a Volatile Stock Market
How to Survive a Market Crash

Evidence identifies factors

Evidence-based investing is, for the most part, a passive investment strategy.

Depending on how it gets executed, there could be active elements involved. Passive strategies with active components are not the same as active management.

Evidence-based investing is also known as factor-based investing.

Studies of the market throughout its history reveal identifiable dimensions or factors that help identify areas of the market offering higher expected returns.

Larry Swedroe is the author of multiple books on investing and Director of Research for The BAM Alliance, a community of over 140 independent registered investment advisory firms. (full disclosure; my firm, Leamnson Capital Advisory, was previously a member of The BAM Alliance).

He's written extensively on factor-based investing and cites the criteria used to validate the factors as follows:

  1. Persistent – The element must be persistent over long periods of time. The best studies cover the period from 1927 to 2017 for US indexes. International time periods are shorter since data has not been available as long.
  2. Pervasive – The factors must be present across different market sectors, countries, regions, etc., including asset classes.
  3. Robust – A factor holds regardless of how you define it. For example, some measured value by price to book. Others may use cash flow or other methods. If robust, the factor will show regardless of how you measure it.
  4. Investable – That means identifying the factor isn't just an academic exercise. One must be able to invest in it to be valid.
  5. Intuitive – There should be logical explanations for why the factor will continue. Some of these might be risk-based. Some might be behavioral. In total, they cannot be explained away as anomalies.

Source: Why Factors Premiums Should Persist, Larry Swedroe, 7/16/18. Originally appeared on ETF.com.

Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today

An efficient market

Factor-based investing started with Nobel Laureate Eugene Fama's seminal research on the markets. He's considered the father of the efficient market hypothesis.

This study, based on decades of research on the functioning of markets, states that markets are efficient. Though there are anomalies from time to time, these are random and nearly impossible to predict. Also, they are mostly not investable.

The hypothesis further states that all information available about any given security is accounted for in its market price; meaning the entire market is smarter than any individual or group of individuals who analyze it.

The result – the price you pay for an investment is a fair price. It is neither over or undervalued.

Now, I realize some reading this might vehemently disagree with this premise.

The image below is an excellent illustration of collective knowledge.

Participants guessed how many jelly beans were in a jar. Answers ranged from 409-5,365. The average guess was 1,653. The actual number was 1,670!

Numerous groups have duplicated this exercise with similar results.

The lesson: the collective knowledge of a group is more accurate than the knowledge of an individual.  Together we know more than we do alone.

That's the efficient market hypothesis in a nutshell.

Image of slide showing jar of jelly beans. Results of folks guessing how many beans are in it listed beside.

The five identifiable factors

Before identifying these factors, let's start with a discussion about risk and returns.

At it's most fundamental level, you must understand that in the investment world, an investment's risk is related to its expected return.

Here's what that means.

The higher the risk of a particular investment, the higher the expected return.

The lower the risk, the lower the expected return.

For this discussion, I will only talk about the risk related to investing in the equity (stock) markets.

Factors identify areas of the market that offer the potential for higher returns. You will hear these referred to as premiums.

The original three factors

  1. The market factor  -stocks are riskier than bonds. Stocks have a higher expected return than do bonds. So far so good, right?
  2. The size factor  -small company stocks are riskier than larger company stocks. Like the market factor, they have a higher expected return.
  3. Value factor  – value stocks are riskier than growth stocks. As such, they have a higher expected return.

The following chart illustrates the long-term performance of these premiums.

Image of line chart showing investment returns from 1927

Recently added factors

The three-factor model stood for decades. In recent years, research included other factors as follows:

  1. Momentum factor – stocks that have outperformed in the past tend to outperform going forward. Unlike the other factors, momentum is a short-term measurement. Typically it uses a three month to a one-year time frame.
  2. Profitability – This is more of a quality measure, and many consider it subjective. As a result, some factor scholars do not include this as a factor. Those that do look at things like debt to equity, quality or earnings, and other financial factors. Analysts looking at profitability are not looking for stocks they think will outperform like the typical active stock fund manager. Instead, they are identifying companies within an asset class (large cap, market equity, small cap, etc.) that use this as a weighting factor rather than a selection criterion. If a stock fits the selection criteria for that asset class, it becomes part of the asset class.

In summary

I think that's enough to digest in part one. We know that the evidence-based investment strategy starts with an understanding and acceptance that the markets are efficient.

From there, we identified the five main identifiable factors that make up the elements of the securities chosen for the strategy. These factors must have these five elements to be valid (persistent, pervasive, robust, investable, and intuitive).

Be sure to come back for part two to discover the role fixed income (bonds play in executing an evidence-based investment strategy.

What do you think? Have you heard about evidence-based investing? Do you believe markets are efficient?

Please let me know in the comment section below. I welcome your feedback. 

Learn about Evidence-Based Investing with this Free PDF

Pursuing better invst

Complete this form and I'll send your FREE copy to the email you provide.

We won't send you spam. Unsubscribe at any time. Powered by ConvertKit
Fred Leamnson
 

I started “Money with a Purpose” to help people “keep it real” when it comes to their money. Many advisors will tell you the only way to success is through planning. I completely agree. And there’s more. You must also align your plan with who you are and what you value. Doing this is THE key to making your money work for you. I started this blog to share with you what that looks like.

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