Evidence Based INVESTING
Once we have built and presented your plan and only then, will we look at what products and funds are best suited to helping you achieve them. When it comes to investing we use an academic evidence based approach to investing to help you achieve these goals.
An evidence based approach to investing is effectively the real-world manifestation of Modern Portfolio Theory, an investment approach envisioned by Nobel Economic prize-winners. Investing often relies on a deeply embedded set of assumptions. In many instances this accepted wisdom is not supported by objective analysis. We have access to market data covering 100 years of investment history, and a wealth of robust academic studies. Important lessons and conclusions can be derived from these studies and applied to investment processes. These insights can help identify and avoid the pitfalls which often erode portfolio performance.
1. Embrace Market Pricing
The market is an effective information-processing machine. Each day, the world equity markets process billions of Euros in trades between buyers and sellers—and the real-time information they bring helps set prices.
With each trade, buyers and sellers bring new information to the market, which helps set prices. No one knows what the next bit of new information will be. The future is uncertain, but prices will adjust accordingly.
This doesn’t mean that a price is always right—there’s no way to prove that. But investors can accept the market price as the best estimate of actual value.
If you don’t believe that market prices are good estimates—if you believe that the market has it wrong—you are pitting your beliefs and hunches against the collective knowledge of all market participants.
2. Don’t Try to Outguess the Market
The market’s pricing power works against fund managers who try to outperform through stock picking or market timing. As evidence, only 18% of US-domiciled equity funds and 15% of fixed income funds have survived and outperformed their benchmarks over the past 20 years. See below the evidence behind US-Domiciled Fund Performance between 2002–2021
Many fund managers believe they can identify “mispriced” securities and convert that knowledge into higher returns. But fair market pricing works against such efforts, as indicated by the large proportion of mutual funds that have underperformed their benchmarks.
In this chart, the light grey bars represent the number of US-domiciled equity and fixed income funds in operation during the past 20 years. These funds compose the beginning universe of that period. The dark grey areas show the percentage of equity and fixed income funds that survived the 20-year period. The blue and green bars show the smaller percentage of equity and fixed income funds that survived and outperformed their respective benchmarks during the period.
Our research shows that over both short and long time horizons, the deck is stacked against mutual funds that attempt to outguess the market.
3. Resist Chasing Past Performance
Some investors select funds based on their past returns. Yet, past performance offers little insight into a fund’s future returns. For example, most funds in the top quartile of previous five-year returns did not maintain a top-quartile ranking in the following five years.
Some investors may resort to using track records as a guide to selecting funds, reasoning that a manager’s past success is likely to continue in the future. Does this assumption pay off? The research offers strong evidence to the contrary. This exhibit shows that among equity funds ranked in the top quartile based on previous five-year returns, a minority also ranked in the top quartile of returns in the following five-year period. A lack of persistence casts further doubt on the ability of managers to consistently gain an informational advantage on the market. Some fund managers might be better than others, but track records alone may not provide enough insight to identify management skill. Stock and bond returns contain a lot of noise, and impressive track records may result from good luck. The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed.
4. Let Markets Work for You
The financial markets have rewarded long-term investors. People expect a positive return on the capital they supply, and historically, the equity and bond markets have provided growth of wealth that has more than offset inflation.
Most people look to the financial markets as their main investment avenue—and the good news is that the capital markets have rewarded long‐term investors. The markets represent capitalism at work in the economy—and historically, free markets have provided a long‐term return that has offset inflation. This is documented in the growth of wealth graph, which shows monthly performance of various indices and inflation since 1975. These indices represent different areas of the global financial markets. The data illustrates the beneficial role of stocks in creating real wealth over time. Euro Short‐Term Rate covered inflation, while global stock returns have far exceeded inflation and significantly outperformed the Euro Short‐Term Rate. Another key point is that not all stocks are the same. For example, consider the performance of Global Small Index stocks and Global Large Value Index stocks over this time period compared to investing in the whole market. A euro invested in the whole market in 1975 would be worth €83 in 2020, compared to €167 for value stocks and €409 for small cap stocks. Keep in mind that there’s risk and uncertainty in the markets. Historical results may not be repeated in the future. Nevertheless, the market is constantly pricing securities to reflect a positive expected return going forward. Otherwise, people would not invest their capital.
5. Consider the Drivers of Returns
There is a wealth of academic research into what drives returns. Expected returns depend on current market prices and expected future cash flows. Investors can use this information to pursue higher expected returns in their portfolios.
Rather than viewing the market universe in terms of individual stocks and bonds, investors should define the market along the dimensions of expected returns to identify broader areas or groups that have similar relevant characteristics. This approach relies on academic research and internal testing to identify these dimensions, which point to differences in expected returns. In the equity market, the dimensions are size (small cap vs. large cap), relative price (value vs. growth) and expected profitability (high vs. low). In the fixed income market, these dimensions are term, credit and currency. The return differences between stocks and bonds can be considerably large, as can the return differences among a group of stocks or bonds. To be considered a dimension, it must be sensible, backed by data over time and across markets, and cost-effective to capture in diversified portfolios. In a dimensions-based approach, capturing returns does not involve predicting which stocks, bonds or market areas are going to outperform in the future. Rather, the goal is to hold well-diversified portfolios that emphasise dimensions of higher expected returns, control costs and have low turnover.
6. Practice Smart Diversification
Holding securities across many market segments can help manage overall risk. But diversifying within your home market may not be enough. Global diversification can broaden your investment universe.
Many people concentrate their investment in their home stock market. They choose only UK stocks and mutual funds and consider their portfolio diversified. In some cases, they only hold a small group of securities. Yet, from a global perspective, limiting one’s investment universe to a handful of stocks, or even one stock market, is a concentrated strategy with possible risk and return implications. This slide offers a conceptual comparison of investing only in the UK market, as represented by the MSCI United Kingdom Investable Market Index (IMI), and structuring a globally diversified portfolio that holds assets in markets around the world, as represented by the MSCI ACWI Investable Market Index (IMI). For the global portfolio, holding thousands of stocks across the world’s developed and emerging market countries broadens one’s investment universe. A diversified portfolio should be structured to hold multiple asset classes that represent different market areas across the world.
7. Avoid Market Timing
You never know which market segments will outperform from year to year. By holding a globally diversified portfolio, investors are well positioned to seek returns wherever they occur.
Even with a globally diversified portfolio, market movements can tempt investors to switch asset classes based on predictions of future performance. But as shown in this table, there is little predictability in asset class performance from one year to the next. This chart features annual ranked performance of major asset classes in Europe and international markets from 2006 to 2020. The asset classes are represented by corresponding market indices. The data shows no obvious pattern of performance across asset classes, suggesting that predicting future performance is a difficult task. The charts offer additional evidence of market efficiency and make a strong case for investors to rely on portfolio structure, rather than market timing, to pursue returns.
8. Manage Your Emotions
Many people struggle to separate their emotions from investing. Markets go up and down. Reacting to current market conditions may lead to making poor investment decisions.
The 2008–2009 global market downturn offers an example of how the cycle of fear and greed can drive an investor’s reactive decisions. Some investors fled the market in early 2009, just before the rebound began. They locked in their losses and then experienced the stress of watching the markets climb. Staying disciplined through rising and falling markets can pose a challenge, but it is crucial for long-term success.
9. Look Beyond the Headlines
Daily market news and commentary can challenge your investment discipline. Some messages stir anxiety about the future, while others tempt you to chase the latest investment fad. When headlines unsettle you, consider the source and maintain a long‑term perspective.
News and financial commentary can influence people’s view of investing. Without a strong investment philosophy to guide them, they also may follow the advice of friends, neighbours or family, especially if the “insight” promises a fast, easy return. But growing wealth has no shortcuts. Success requires a solid investment approach, a long-term perspective and discipline to stay the course.
10. Focus on What You Can Control
A financial adviser can offer expertise and guidance to help you focus on actions that add value. This can lead to a better investment experience.
To have a better investment experience, people should focus on the things they can control. It starts with an adviser creating an investment plan based on market principles, informed by financial science and tailored to a client’s specific needs and goals. Along the way, an adviser can help clients focus on actions that add investment value, such as managing expenses and portfolio turnover while maintaining broad diversification. Equally important, an adviser can provide knowledge and encouragement to help investors stay disciplined through various market conditions.
if it sounds to good to be true, thats because it probably is
The truth is markets are hard to beat consistently. Picking stocks & funds on the view that prices are wrong is like betting on the horses. It can go either way. Not even the professionals are much good at market timing. And as for guarantees, think about this: If there were no risk in investing, why would there be a return?
We have two resources to help you learn a bit more about the truth around investing,
A link below to a free book around evidence based investing, which looks at an investment approach based on evidence, one that is grounded in empirical research and the long-term observation of markets and how they work.
The approach we use to help you achieve your goal is not an approach based on guesswork, gut feeling or hunches, or the idea that any single person has some magic formula for seeing into the future. It is an approach based on verifiable facts and observation.
It is the approach that we at Fortress Financial Planning believe in and will strive to help you understand and bring to your overall portfolio as part of the financial planning process.