Key Investment Insights: What Has Evidence-Based Investing Done for Me Lately?
October 2, 2014
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Welcome to the next installment in our series of Key Investment Insights. In our last piece, we introduced three key stock market factors (equity, value and small-cap) plus a couple more for bonds (term and credit) that have empirically formed the basis for evidence-based portfolio construction.
Continued inquiry has found additional market factors at play, with additional potential premiums (which, of course, are a result of market risk and/or risky behaviors). In academic circles, the most prominent among these factors are profitability and momentum:
- Profitability – Highly profitable companies have delivered premium returns over low-profitability companies.
- Momentum – Stocks which have done well (or poorly) in the recent past tend to continue to do the same for longer than chance would explain.
A Closer Look at Newer Factors
As expected, there are a few caveats.
- Wet Paint Warning – While so-called “new” factors may or may not really be so new, our ability to isolate them is more recent and as a result, some among the evidence-based community are still assessing their staying power.
- Cost versus Reward – Just because a factor does theoretically exist doesn’t mean it can be implemented in real life and, even if it can, that it is worth implementing. We must be able to capture an expected premium without generating costs beyond its worth.
- Competing Factors – Sometimes, the inclusion of one factor in an investment strategy results in the sacrificing of another. For example, as Jared Kizer explains in his Multifactor World blog post, “One generally can’t tilt toward both value and momentum at the same time, because the two strategies tend to be highly negatively correlated.” Benefits and trade-offs must first be carefully considered.
As a result, opinions vary on when, how or even if, profitability, momentum and other newer factors should play a role in current portfolio construction. To help you determine whether any newer factor makes sense for you, let’s look at how investment information is assessed.
Investment Information: A Double-Edged Sword
Relentless questioning from scholars and practitioners has been essential to evidence-based investment theory and application, dispelling illusions and misconceptions and laying the foundation for other insights.
But, with a glimpse of the day’s headlines, one can’t help but notice a seemingly never-ending stream of ideas, often from competing, sometimes conflicting, voices of authority. Information overload can, unfortunately, do as much harm as good.
Investment Reality: Choose Your Allies Carefully
So, how do you know what information to heed and what to ignore? This is where we believe an evidence-based advisor relationship is critical to your wealth and well-being. As we outlined in “The Essence of Evidence-Based Investing,” whenever we assess the validity of existing and emerging market insights, we ask pointed questions that can take years to resolve:
- Have the results been replicated over time and around the world?
- Is there robust analysis, not only from industry insiders but from disinterested academics?
- Has it survived extensive peer review, if not unscathed, at least free of mortal wounds?
By considering each new potential factor according to strict guidelines, our aim is to extract the diamonds of promising new evidence-based insights from the considerably larger piles of misleading misinformation. We feel you are best served by heeding those who take a similar approach with their advice. In our next Key Insight, we turn to a factor which we believe may be the most influential of all: you and your financial behavior.