Key Investment Insights: The Essence of Evidence-Based Investing

September 17, 2014
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Welcome to the next installment in our series of Key Investment Insights. In our last piece, “What Drives Market Returns?” we explored how markets deliver wealth to those who invest their financial capital in human enterprise. But, as with any risky venture, there are no guarantees; no guarantee that you’ll earn the returns that you’re aiming or hoping for, and no guarantee that you’ll even recover your original stake. This leads us to why we so strongly favor evidence-based investing. Grounding your strategy in rational methodology can help you stay on course toward your financial goals.

So what does evidence-based investing entail?

Market Return Factors: The Essence of Evidence-Based Investing

Over the last five decades, a “Who’s Who” body of scholars has been studying financial markets in order to answer investors’ most pressing questions, including:

  • What drives returns? Which return-yielding factors appear to be persistent over time, around the world and across a range of market conditions?
  • How does it work? Once identified, can we explain why particular return-yielding factors exist, or at least narrow it down to the most likely causes?

Financial Scholar vs. Financial Professional

Building on this academic inquiry, fund companies and other financial professionals have an equally important task: Even if a relatively reliable return premium does theoretically exist, can we capture it in the real world – after the implementation and trading costs involved?

As in any discipline, from finance to biology, it’s in academic researchers’ interest to discover the possibilities and it’s in our interest to figure out what to do with that understanding. This is, in part, why it’s important to maintain the separate roles of financial scholar and financial practitioner, to ensure that each of us is doing what we can do best.

The Rigors of Academic Inquiry

In academia, rigorous research typically demands:

A Disinterested Outlook – There should be no hidden agenda, other than to explore intriguing phenomena and report the results.

Robust Data Analysis – The analysis should be free from weaknesses such as:

  • “Suspect” data, i.e. data that is too short-term, too small a sampling or otherwise tainted.
  • “Survivorship bias,” in which the returns from funds that were closed during the study are omitted from the results.
  • Apples to oranges comparison, i.e. using an inappropriate benchmark against which to assess a fund’s or strategy’s “success” or “failure.”
  • Insufficient use of advanced mathematics like multi-factor regression, which helps pinpoint the critical factors from among myriad possibilities.

Repeatability and Reproducibility – Results must be repeatable and reproducible by the author and others, across multiple, comparable environments. This strengthens the reliability of the results and helps to ensure the outcomes weren’t just random luck.

Peer Review – Last, but hardly least, scholars must publish their detailed results and methodology, typically within an appropriate academic journal, so similarly credentialed peers can review their work and agree that the results are sound or rebut them with counterpoints.

Your Takeaway

As is the case in any healthy scholarly environment, those contributing to the lively inquiry about what drives market returns are rarely of one mind. Still, when backed by solid methodology and credible consensus, an evidence-based approach to investing offers the best opportunity to advance and apply well-supported findings in order to strengthen the ability to build and/or preserve long-term personal wealth according to your unique goals.

Next, we’ll further explore market factors and expected returns. 

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