Replace guesswork with planning, costs with efficiencies, and emotions with evidence.
Successful investing usually has more to do with investor behavior than it does with market performance. When markets are on the rise, active investors chase the trend without realizing it could turn on a dime. When markets plummet, they grew gloomy and sell – often just before the next recovery.
Unfortunately, investors who succumb to this type of stressful “actively managed” investing are missing out on what decades of evidence tells us is a more sensible approach to capturing the market’s expected long-term returns. It’s called evidence-based investing.
Evidence-Based Investing in Efficient Markets
Active investors assume that the market is generally “inefficient.” If the market were inefficient, it would mean that clever individuals (or their clever brokers) could regularly exploit opportunities when holdings were trading for more or less than they were actually worth. Opportunities would need to be of sufficient frequency and value to cover the costs of consistently seeking and executing such trades.
There is significant academic evidence that the collective wisdom of all market players — especially in today’s electronic era — results in highly efficient markets that reflect fair pricing almost instantaneously upon release of any news (good or bad) that might affect a holding’s price.
An evidence-based investor assumes that opportunities to exploit inefficiencies are too few and far between to cost-effectively pursue. It would be like spending one’s day trying to find lost dollar bills on the sidewalk. It’s fun if you have such luck, but it’s no way to earn a living.
Evidence-Based Investing To Control Costs
Evidence-based investing also provides a highly effective way to address another factor that is critical to your investment success: Controlling costs.
Research and reason alike inform us: All else being equal, we would expect lower costs to lead to higher returns.
Beyond account management expenses, there are many other costs to be managed, including trading/turnover expenses, taxes and “the cost of cash” (incurred when a mutual fund holds a portion of your assets in cash rather than fully invested, continuously earning market returns). Evidence-based investing is not the only way to seek to minimize such expenses, but we have found it to be a highly effective way. It’s an approach that helps investors, their advisors and fund managers alike shift their focus away from hyperactive (costly) trading and toward cost-effective asset allocation, tax-efficient asset location, and stay-the-course discipline in volatile markets.
Evidence-Based Investing and Appropriate Asset Allocation
Perhaps the most important determinant of portfolio performance is asset allocation — how your assets are exposed to various return factors. Because effective asset allocation requires your portfolio to maintain consistent exposure to these factors, the investment vehicles from which you build your portfolio also need to stay within their targeted asset classes. Unfortunately, in most retail actively managed funds you effectively relinquish control of your asset allocation to others. Such funds may overweigh or underweigh specific parts of the market in their quest, chase or flee near-term market volatility, or move a portion of your assets out of the market entirely. We prefer funds that remain steadfastly invested in the asset classes they represent, so allocations can be deliberately managed according to plan.
Why Our Firm Espouses Evidence-Based Investing
We conclude with why our firm has adopted an evidence based approach to investing. We believe our approach fosters a relationship grounded in fiduciary obligation, while effectively incorporating academic evidence on how markets can be used to pursue your financial independence. In this way, our and our clients’ goals are best aligned.