Dive into the world of evidence-based investing, where empirical research meets portfolio construction. This episode unravels the science behind applying successful investing strategies and avoiding mistakes that can hinder your financial growth.
Listen now and learn:
- Foundational principles behind evidence-based investing
- Insights into optimizing your portfolio for long-term
- Ways to avoid the typical pitfalls of individual and professional investors
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Show Notes
Founded in October of 1983, Plancorp is celebrating its 40th anniversary this month.
Our founder, Jeff Buckner, started Plancorp as one of the country’s first fee-only, fiduciary wealth management firms. The concept was uniquely innovative in the 1980s since the financial services landscape was dominated by brokers and insurance companies.
In fact, I’d argue the 40 years of success Plancorp has experienced comes from this desire to always do what’s best for the client. It guides the investing, planning, and service philosophies that have helped thousands of families establish legacies and make an impact for generations to come.
In honor of Plancorp’s 40th anniversary, I’d like to celebrate and specifically focus on Plancorp’s evidence-based investment philosophy.
What is Evidence-Based Investing?
Imagine you’re an explorer from centuries past, setting out to discover new lands. You’ve heard tales and fables about golden cities and mystical terrains, but they’re mixed with whispers of perilous landscapes and insurmountable challenges. Embarking on this journey without a reliable map would be reckless. This map, in the financial realm, is what we call evidence-based investing (EBI).
EBI isn’t about attempting to predict the unpredictable. Instead, it’s about relying on the accumulated wisdom of years of market behavior, rigorous academic research, and empirical evidence. It’s the compass that points true north when the siren songs of market myths and fables beckon.
History has shown that while markets are influenced by a myriad of factors, certain patterns and behaviors tend to repeat themselves. EBI is the study and application of these patterns. Instead of being swayed by every market rumor or getting caught up in the frenzy of the latest financial trend, evidence-based investors adopt a disciplined, methodical approach.
But EBI isn’t just about cold, hard data. At its core, it’s a deeply human philosophy. It acknowledges our natural tendencies toward fear and greed, optimism and pessimism. By rooting decisions in evidence, it provides a buffer against these emotional swings, ensuring we navigate the financial landscape with a steadier hand.
In essence, evidence-based investing is like having the notes of seasoned explorers who’ve traversed the financial terrains before us. It’s a reminder that while the world of investing is vast and often daunting, with the right map, we can make the journey with confidence.
In this episode, I’d like to explore a few key principles of an evidence-based investment philosophy.
Reliance on Empirical Research
The first and perhaps most important principle of EBI is that it relies on academic research and historical data to inform investment decisions.
No investment advice should be given unless and until it is adequately supported by good evidence; however, evidence almost always cuts in multiple directions.
It’s a lot like when the FDA evaluates a new drug, they seek to minimize the chance of approving a drug that is not beneficial to people’s health or causes bad side effects. In doing so, they increase the probability of failing to approve a drug that would improve people’s health. This is a tradeoff between minimizing Type I and Type II errors.
The same tradeoff occurs when evaluating which exposures to include in your portfolio. You can minimize Type I errors by owning a couple of broad market index funds and never seeking further enhancements to your portfolio. Minimizing Type II errors, on the other hand, means setting a very low bar for implementing a new strategy.
The tricky part is that minimizing one error leads to a higher chance of realizing the other error.
The key is to strike a good balance. But the thing I find fascinating about evidence-based investing is that people can look at the same data and come to different conclusions depending on their preference for minimizing Type I or Type II errors.
At Plancorp, we know that each additional strategy has a diminishing marginal benefit. In addition, the costs of implementing additional exposures at the portfolio level (not just the fund level) increase the uncertainty regarding the net benefit from inclusion.
For these reasons, we tend to be more concerned with implementing a bad idea than missing out on a good one. In other words, we prefer to lean towards minimizing Type I errors.
Asset Allocation and Diversification
Decades of financial research have overwhelmingly shown that asset allocation is the primary driver of differences in returns. For all the amount of time investors, including myself, spend studying and debating investment strategies, no single choice will have a greater impact on returns than your mix of stocks and bonds.
Similarly, empirical research overwhelmingly shows that a diversified portfolio reduces volatility, mitigates risks, and offers a smoother investment journey.
Individual stocks rise and fall. Sectors boom and bust. Geopolitical events, technological breakthroughs, and yes, even pandemics, can turn the tables overnight. Diversification, in essence, is the acknowledgment of this inherent uncertainty. It’s an admission that while we can’t predict the future, we can prepare for it.
Diversification isn’t about maximizing returns every time; it’s about minimizing the odds of massive failure. This is a key point to remember because owning a well-diversified portfolio always means a portion of your portfolio will disappoint you. Being well-diversified means owning the winners and the losers.
When one asset underperforms, another might be having its moment in the sun. This balance ensures that you’re less likely to make rash decisions based on short-term movements, keeping you firmly on the path defined by your long-term goals.
One final point before moving on from diversification: if there’s one lesson that history has hammered home repeatedly, it’s the perils of concentration.
I also talk about this in EP.118: 4 Ways to Diversify Concentrated Stock Positions and in EP.63: Should You Invest in Individual Stocks?
By spreading investments, we acknowledge our own fallibility and protect ourselves from unforeseen calamities.
The Perils of Market Timing and Performance Chasing
EBI suggests that consistently predicting market movements is challenging, if not impossible, for most investors. Instead of trying to time the market, EBI focuses on long-term investment strategies.
Market timing is a tantalizing concept. It’s the financial equivalent of a high-stakes poker game, where players believe they can outsmart their opponents with the perfect bluff. Investors, seduced by the allure of quick profits, try to predict the market’s next move, buying low and selling high. But here’s the paradox: while market timing seems intuitively logical, it’s a strategy fraught with pitfalls.
Let’s start with a simple acknowledgment: Markets are unpredictable beasts. They’re influenced by a cacophony of factors, from geopolitical events and economic indicators to corporate news and market psychology. Predicting how all these elements will intersect at any given moment is akin to forecasting next month’s weather with pinpoint accuracy. It’s a game of chance, not skill.
Historically, the markets have demonstrated their penchant for the unexpected. Black Swan events, named after the once-presumed mythical bird, are by definition unpredictable, yet they have a significant market impact. The dot-com bubble of the late 1990s and the financial crisis of 2008 were watershed moments that few, if any, saw coming. In both instances, those attempting to time the market either missed out on initial gains or were caught in the downward spiral, reacting too late.
The empirical research is clear: individuals and professional investors consistently underperform broad market benchmarks.
But perhaps even more concerning is the research that shows individuals consistently underperform the very funds they are investing in, meaning they buy and sell the funds at the wrong time.
I’ll be honest, most people I’ve worked with throughout my career accept the fact that they can’t time when markets will move in one direction or another. However, there is an overwhelming number of people who want to make investments based on recent returns. This is what is referred to as “performance chasing,” which in my opinion is simply market timing exhibited in a different manner.
Performance chasing is relatively self-explanatory. It occurs when investors want to own more of what has performed well recently and/or less of what has recently performed poorly.
For example, I’ve spoken to many individual investors and non-profit institutions that wanted to make changes to their bond allocations based solely on bond market returns in 2022, which by the way was the worst year in bonds EVER.
I address this in detail in EP.109: Should You Hold Cash Instead of Bonds Right Now?
For the past several years, performance-chasing tendencies have been most prevalent when considering International vs US stocks.
What’s funny is that I can clearly recall conversations from 2010 following the last decade in US stocks in which the S&P 500 had a negative average annual return the prior decade. So many investors were eager to abandon their target allocation to US stocks in favor of non-US equities, especially Emerging Markets. Fast forward to today and the opposite is true. Now that US stocks have trounced their non-US counterparts, many investors want to reduce their International and Emerging Market allocations.
In EP.107: Are US Stocks Enough For Your Portfolio? I talk more about owning international stock.
The allure of market timing manifests in a variety of ways and will always persist. It’s fueled by overconfidence and the inherent human desire for control. We crave narratives, and the idea of being the savvy investor who “saw it coming” is an irresistible story.
However, evidence-based investing nudges us to rise above these narratives and recognize the bigger picture. It encourages us to embrace humility, to admit that we can’t foresee market twists and turns.
The Importance of Low Costs
Imagine two runners racing a marathon. They start simultaneously, but one has a backpack filled with bricks. As the race progresses, the weight drags the runner down, making each stride harder, and each mile more exhausting. By the end, the burdened runner is far behind his counterpart. In the world of investing, costs are those bricks.
Evidence-based investing isn’t just about what you earn; it’s about what you keep. And costs are the silent predators, nibbling away at your returns, year after year. And unlike so many other facets of investing that are completely unpredictable, fund fees are one of the few variables you can control.
Evidence suggests that funds with lower costs tend to outperform their more expensive counterparts over time, but this doesn’t mean you necessarily need to only utilize the lowest-cost investments. Such a strategy would effectively mean only using index funds—that’s not necessarily a bad thing, but it isn’t necessarily the optimal choice for all investors.
It can make sense to pay higher fees when you’re getting something of value, such as systematic exposure to factors that have higher expected returns or geographic regions (such as Emerging Markets) that are more costly to implement.
But paying more for active management that relies on security selection and market timing isn’t obviously adding value. In fact, there is an overwhelming amount of evidence that higher costs eat away any benefit active managers might provide.
Twice a year, Standard & Poor releases a report on the percentage of active managers failing to beat their benchmark. Every time, you’ll see at least 80-90% of active managers fail to beat a simple index—and yet, they charge much higher fees. Now, there are some extraordinarily low-cost actively managed funds out there—with fees only modestly higher than the benchmark they seek to beat—but most active funds charge a premium that simply isn’t worth it.
However, the seductive allure of active management often blinds investors to this reality. There’s a natural human tendency to believe that if you’re paying more for something, it must inherently be better.
In many realms, this might hold true. But the world of investing is counterintuitive. Here, paying more doesn’t necessarily get you better performance. As a result, evidence-based investing tends to emphasize low-cost or rules-based strategies that allow investors to keep more of their returns.
Behavioral Awareness
Behavioral finance, the fascinating intersection of psychology and finance, has unveiled a series of cognitive biases that influence our decision-making processes. From the overconfidence bias, where we mistakenly rate our abilities higher than reality, to loss aversion, where the pain of a loss feels twice as potent as the joy of a gain, these biases are hardwired into our psyche.
So, why is behavioral awareness paramount in the EBI doctrine? Because investing isn’t just a numbers game; it’s a psychological journey. Historical market data might suggest one course of action, but our inner fears or desires can pull us in a different direction. And often, these emotional detours can be costly.
EBI urges us to introspect, to recognize these biases, and to develop strategies to counteract them. It’s about cultivating an awareness that markets might be external entities but the responses they evoke are deeply personal.
In essence, EBI isn’t just about external market evidence; it’s also about the internal evidence of our own behaviors.
Regular Rebalancing
Rebalancing, at its core, is about realigning. It’s a periodic return to an original plan.
Picture a masterful gardener, carefully tending to a meticulously designed landscape. Over time, certain plants flourish, overshadowing others, and altering the garden’s original harmony. The gardener must regularly prune back the overgrown sections and bolster the weaker ones, ensuring the garden retains its intended design. This, in essence, is the principle of regular rebalancing in evidence-based investing (EBI).
Markets are dynamic entities. Asset classes don’t grow at the same pace. A booming sector today could be tomorrow’s laggard. Over time, these fluctuations can cause a portfolio’s actual allocation to drift from its target. An investor might start with a 60-40 split between stocks and bonds, but after a strong year in the stock market, one might find themselves heavily skewed towards stocks. This new allocation might not align with their risk tolerance or financial goals.
Enter rebalancing. By periodically adjusting the portfolio – selling assets that have appreciated and buying those that have fallen relative to their intended allocation – investors can ensure they remain on track. It’s a proactive commitment to a strategy, an assertion that despite the market’s oscillations and the economy’s ever-changing dynamics, the original plan still holds value.
But there’s another layer to rebalancing, one that resonates deeply with the EBI philosophy: discipline. The world of investing is awash with noise. Daily headlines scream about market highs and lows, about sectors that are “hot” and those that are “not”. It’s all too easy to be swayed, to chase after the flavor of the month. Rebalancing is an antidote to this. It’s a ritual that forces investors to buy low and sell high, often contrary to prevailing market sentiments.
Stay the Course
Given the inherent volatility of markets, evidence-based investing encourages investors to stay committed to their investment strategy, especially during market downturns.
When the market goes down, our human fear instinct kicks in and makes us feel the need to do something. When our ancient ancestors heard a rustle in the bushes, fear made them run. They didn’t have time to calculate the probability that the noise in the bushes was a lion versus the wind. Taking the time to think about it posed too much of a risk of being pounced on. Better to get away first and evaluate later.
Thankfully, most of us no longer need to worry about being hunted down by lions, but that instinct to react when we feel afraid or threatened remains. That makes it tough to not react when we get spooked by the stock market.
We never know when or why the next correction or bear market will happen. What we do know is that market downturns happen on a regular basis. Rather than trying to predict the timing or cause of the next downturn, you’re better off planning on historical levels of volatility persisting over time.
Investors must be willing to lose money on occasion – sometimes a lot of money – to earn the average long-term return that attracts most people to stocks in the first place. The good news is that you can reduce the chance of loss by agreeing to stay invested over a long period of time.
Staying the course isn’t about blind rigidity. It’s about informed perseverance. At Plancorp, we make investment decisions within the context of a multi-decade time horizon. Not only do we know markets will regularly experience downturns, but we accept that strategies will fall in and out of favor.
In the moment, the long term feels like an eternity to live through, but the most basic parts of financial theory look pretty darn good when you allow them time to work. And investors who maintain discipline and stay the course will be rewarded over time.
Resources:
- EP.22: To Add Or Not To Add?
- EP.63: Should You Invest in Individual Stocks?
- EP.118: 4 Ways to Diversify Concentrated Stock Positions
- EP.109: Should You Hold Cash Instead of Bonds Right Now?
- EP.107: Are US Stocks Enough For Your Portfolio?
- EP.74: The Failure Of Active Management
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About the Podcast
Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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