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Of doctors and snake oil salesmen

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Gareth Stobie is the MD of Coreshares.

The barrage of market noise, political headlines, incessant commentary and analysis makes it very difficult for investors to remain objective and stay the course. What they need is an evidence-based approach to investing

A few days ago, I visited my physio with a middle-aged sports injury. We started discussing the pros and cons of ultra-sound. The physio, a consummate professional, immediately began to cite the publications and evidence for or against its use. It reminded me of where the medical profession stands relative to my own profession in investment management.

Mark Ebell, a professor at the University of Georgia, defines evidence-based medicine as the “conscientious, explicit, and judicious use of current best evidence in making decisions about the care of individual patients”.

I’d go along with this approach — you? I guess the alternative is a sort of “learned guess” or trial-and-error approach, which may yield results, but may also go horribly wrong.

The question is, how much of the investment industry is premised on such an evidence-based approach — an approach supported by facts and research — and how much of it is learned guesswork? It’s not as if the stakes are any lower; financial health and physical health are two of life’s essential pursuits.

While I have huge respect for the calibre of people within the investment industry, which attracts some of the finest minds, I challenge the humility of my peer group. All too often the focus is on having all the right answers on issues which, frankly, have little to do with the problem at hand.

The aim, remember, is to ensure families meet their financial goals. Investment managers should be more focused on the financial planning problem, which has less to do with the headlines dominating our news or having the answers as to how near-term events may or may not play out — these questions tend to be unanswerable. In our profession, many are guilty of making investment decisions based on predictions, rather than simply falling back on the tried-and-tested evidence that’s available. At most investment conferences I attend, there is plenty of bravado as to who has the right prediction, rather than a focus on the client and the client’s needs.

John Bogle, credited as the father of index fund investing, once quipped:

The mutual fund industry has been built, in a sense, on witchcraft.” A dig at those who believe they can make near-term predictions of markets, individual shares, interest rates, and so on.

Evidence-based investing (EBI) is an investment approach that aims to follow the world of modern medicine, focusing on facts and aiming to avoid unanswerable, often irrelevant questions: Questions which are more subjective and less important to the longer-term investment outcomes of clients (such as near-term movements in equities, interest rates and currencies).

Rather, it centres around answerable questions such as what asset allocation makes sense given a certain time and risk tolerance? Or, what is the best way to structure my investments to create a required income stream? By focusing on evidence and facts, we can systematically tackle these questions.

The term “evidence-based” has copped some criticism; many would argue all investment decisions are surely based on certain bodies of evidence (analyst reports, leading indicators and so on). But we can’t process the conclusions derived from these sorts of forward-looking predictions with accuracy or consistency. We should focus on bodies of evidence that are peer-reviewed, time-tested and academic in nature.

To articulate the term EBI, financial blogger Phil Huber interviewed some thought leaders advocating for the adoption of an evidence-based approach: Huber summarised the process into this quirky formula:

One thing I have learned about EBI over the years is that it’s less a map telling you exactly where to go and how to get there and more an internal compass of investing principles that are supported by data, theory and common sense.”

So what are the some of the pieces of evidence we can reliably use when investing? There are many, but perhaps four of the key elements are:

Asset class return characteristics: We have an excellent understanding of how asset classes are likely to reward through time and over different periods. We know for instance that a young person with a long time horizon and high-risk tolerance should be broadly exposed to equities. The specific types of stocks are less relevant — the evidence shows that stock-picking relative to the market is incredibly difficult — hence the focus on index funds.

Diversification: Described as “the only free lunch in investing”, it is a mathematical truth that by holding uncorrelated assets and shares, we can expect the same level of returns, but at a lower level of risk.

Cost: Cost is a structural drag on an investor’s returns. By keeping costs low, we can improve returns — evidence shows that cost is one of the main predictors of future returns. Lower cost = higher returns.

Factors (smart beta): There is a significant body of evidence demonstrating that shares with certain risk attributes offer a risk-reward profile that is different from the general market. Though a more technical area of the asset management industry, evidence shows that exposure to these risks over time can generate higher investor returns. For example, evidence shows that over the long term, smaller companies outperform larger companies (the “size” factor).

Along with these elements is a stronger focus on the behavioural aspects that often hold investors back from realising their investment goals. It is critical to stay invested and not chop and change your strategy. DM

 

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