Evidence-based Investing, Part One

Just as evidence-based medical care utilizes fact-based best practices in treating illness and disease, it is possible to use research from the academic community in making investment decisions.  Evidence-based investing is really a bridge between academic finance research and practical portfolio management. That’s a mouthful, but what it comes down to is attempting to maximize potential returns, while limiting risks and avoiding common mistakes.

It all started in 1952 when Harry Markowitz published a seminal paper called Portfolio Selection.  He wrote about risk and return and the value of diversification. It may seem commonplace now, but at the time it was groundbreaking.

Markowitz simply said that investors should be more concerned with the characteristics of their portfolio than in choosing individual investments.  He concluded that while investors cannot control the “risk” of individual stocks, they can control the variability (risk) of an entire portfolio with proper diversification.  Of course he proved his point with a lot of mathematics and statistical analysis.  But underneath it was an elegant exposition of a simple concept that your grandmother not only understood, but probably often quoted – don’t put all your eggs in one basket.

Academic research has ballooned since the 1950s.  There have been thousands of studies trying to explain how investors do (and should) behave. The old rule of “publish or perish” certainly applies to professors of Economics and Finance, yet many of the papers were published in journals that very few investors even know existed, such as the Journal of Finance, The Journal of Financial Economics, and the Journal of Portfolio Management.

Harry Markowitz earned a Nobel Prize in 1990 along with Merton Miller, and William F. Sharpe for their work in “Financial Economics.”   The body of work developed by them and others has become known as Modern Portfolio Theory (MPT).  This approach is not foolproof, and the advice is based on models, not truth written in stone.  And, of course, MPT can be misinterpreted and used incorrectly, sometimes (unfortunately) to sell questionable investment products.  Nevertheless, the practical implications of MPT – focusing on risk and return – are extremely valuable for investors.

You really don’t have to understand all of the details of terms such as the Capital Asset Pricing Model, Alpha, Beta, the Sharpe Ratio, and Portfolio Optimization; there’s no test, after all.  But you should be aware of the major conclusions and practical applications.

One major topic previously discussed in this blog is the difference between active and passive management of investments.  This dichotomy comes straight out of the research that academic economists have performed.

Similarly, you don’t have to read the research of Eugene Fama and Ken French, nor do you need to understand the Fama-French three-factor model, but it would certainly be helpful if your investment manager did.

Actually, Fama and French are quite accessible on their blog.  If you check out the Fama/French Forum, which I highly recommend, you will notice a logo that says “hosted by Dimensional.”

Dimensional Fund Advisors (DFA) is a company best known for applying academic research to portfolio management.  DFA has been referred to as “the best mutual fund company you’ve never heard of.”

To be continued.