Everyone loves a good story. It’s what keeps you hooked watching a movie or reading a book…it’s also what keeps investors committed to poor investment solutions. Investors like a good story that keeps them engaged, and that story usually involves a savvy manager. But there is a different narrative—written by financial scientists.
Now, academic finance isn’t exactly an engaging story. However, it has changed the face of investing and market analysis for every investor. In the 1960’s, University of Chicago romance-language-scholar-turned-economist Eugene Fama and his protégé’s (namely, Michael Jensen of Jensen’s Alpha performance measurement “fame”) first used the power of advanced computing and the capital asset pricing model (CAPM) to price securities and study what impacts returns. Their breakthroughs in finance led to an understanding that, on average, mutual fund managers don’t outperform the market, as well as the idea that there are other factors in the marketplace that contribute to investment returns.
Enter: Evidence-based investing
Evidence-based investing is about identifying the characteristics of stocks that have outperformed in the past, and building portfolio strategies that overweight stocks that have these particular characteristics. It’s about finding companies that have the right factors. Those factors are size, value (the price investors are willing to pay for a dollar of profit), and profitability. The investment industry spends far too much time and money chasing alpha (excess return) and not enough time paying attention to science. Ken French, professor of finance at Dartmouth, estimated in 2008 that over $100 billion is spent chasing returns that can’t be explained by the market. This pursuit is funded by investors in the form of high expense ratios and management fees.
So if financial science tells us what factors contribute to investment returns, and that the pursuit of excess returns through trading and stock picking doesn’t translate to consistent outperformance, how should an investor approach investing during times of tumult? While it is alluring to believe the story of the supposed savvy manager and view world events as if they will precipitate a cataclysmic downfall of the world and market as we know it (or the opposite, depending on the day), this is what we actually do for our clients.
1. Eliminate Meaningless Questions
· What is the best way to capture market returns? Do professional money managers perform better than the index? Can timing the market improve returns?
2. Ask Meaningful Questions
· What is the best asset allocation? Is international diversification advantageous? Are small and value stocks preferable to large and growth? Should a diversified portfolio invest in assets other than stocks or bonds? Is there a meaningful and consistent connection between the risk and return of an investment?
3. Apply the Evidence
· Investment selection of broad-based market funds that are low-cost, transparent and tax-efficient.
· Regular rebalancing as a discipline to control long-term risk and enhance return.
4. Proactively Monitor
· Robust investment oversight, paying attention to the current state of knowledge in financial economics.
Famed manager Peter Lynch once said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” The evidence-based story can’t explain presidential election outcomes, international geo-political intrigue, or why the Fed isn’t raising interest rates. However, it is a story that keeps an investor grounded and successful over years of daily tumult across the globe. Everyone loves a good story…this one is ours, and we are compelled by the evidence to stick to it.
Sources: Research on Wealth, Spring 2017