March 31, 2022

Understanding Evidence-Based Investing

Evidence-based investors build and manage their portfolio based on what is expected to enhance future returns and/or dampen related risk exposures, using the most robust evidence available to make these calls. This also means sticking with your long-view, evidence-based strategy once it’s in place, despite the market’s uncertainties and your own self-doubts you’ll encounter along the way.

The History of Evidence-Based Investing

At its core, evidence-based investing believes investors can come out ahead by finding mispriced stocks, bonds, and other trading opportunities while dodging in and out of rising and falling markets. This has been the case since at least 1952, when Harry Markowitz published Portfolio Selection in The Journal of Finance. In this essay, Markowitz provided a theory and a process for creating a diversified portfolio.

Markowitz’s work became known as Modern Portfolio Theory (MPT). Academics and practitioners have been building on it ever since. His initial work and others’ subsequent findings strongly support ignoring all the near-term noise and taking a long-view approach. This involves building a unified investment portfolio, and focusing on more manageable details, such as:

  • Tilting toward or away from entire asset classes to tailor your risks and expected returns
  • Minimizing avoidable risks by diversifying globally
  • Reducing unnecessary costs
  • Controlling your own damaging behavioral biases

How Do You Decide Which Evidence to Heed?

At first, nearly every investment recommendation may seem “evidence-based,” but the critical difference is how we apply them as evidence-based investors. No matter how compelling a call to action may be, we discourage frequent reaction to the never-ending onslaught of information.

Instead, we should ask: Which information might add substantive value to our decisions by refuting or adding to the existing evidence? Which is just more of the same old noise, already factored into your evidence-based investment strategy?

Evidence-Based Investing requires robust data sets that are large enough, representative enough, and free from other common data analysis flaws. Authors should be impartial, and other studies should be able to reproduce the same findings under different scenarios. Additionally, the data, methodology, and results should be published in reputable, peer-reviewed forums where informed colleagues can comment on the findings.

Evidence-Based Investment Factors

Which factors appear to best explain different outcomes among different portfolios? In what combinations are these factors expected to create the strongest, risk-adjusted portfolios?

We typically mix and match the following factors in our evidence-based portfolios, varying specific exposures based on each investor’s personal goals and risk tolerances:

  • The Market: Stocks (equities) vs. bonds (fixed income)
  • Company Size: Small vs. large company stocks
  • Relative Price: Value vs. growth company stocks
  • Profitability: High-profit vs. low-profit company stocks
  • Term: Long-term vs. short-term bonds (based on maturity date)
  • Credit: “Safer” vs. “riskier” bonds (based on credit quality)