Have you ever heard the term “bloodletting”? Bloodletting was a tactic used by the medical community to prevent or cure illness. In the old days, the collective wisdom was that our blood was one of many systems in our body that must remain in balance at all times. If you walked into a doctor’s office with a common affliction like the flu or a cold, the doctor might determine that you simply had too much much blood in your body. A common prescription was to apply leeches to your skin to bring relief.
Why did they believe this craziness worked? Their anecdotal experience, speculation, and conjecture.
So how did we figure out that bloodletting was probably doing more harm than good? Researchers began applying science to the practice of medicine in the late 1800s. The scientific method of hypothesizing, gathering data, testing, and using analysis to come to a reasonable conclusion helped us figure out that our problems were not because we had too much blood. They came from other things like viruses, bacteria, and our genetics.
Evolution of Investing
This revolution in western medicine is similar to what we’re seeing in investing today. For years and years the investment process has been driven by anecdotal observation and conjecture.
For example, how many times have you read an article in Forbes or The Wall Street Journal that profiles the “next big stock to pop”? In the 90’s it was tech stocks, in the 2000’s it was banking and pharmaceuticals, and since then it’s been social media and tech stocks. Buying a stock that you think is about to pop, or is undervalued, has been one of the preeminent investment strategies since the early 1900s.
The same goes for “tactical” asset allocation. Boosting your portfolio’s allocation to oil stocks because you think OPEC is about to cut their production quotas, or selling bonds because you think interest rates are about to rise are strategies based on speculation about the future.
Why do so many people invest this way? Because of our life experience & anecdotal observations. Everyone I’ve ever met has at least one person they know who invested early in Facebook or Microsoft and made a fortune. We believe this type of investing can work because of our anecdotal experience.
Evidence Based Investing
Over the last 15 to 20 years, the scientific method has started to be applied to investing. Academics and researchers far more intelligent than me are using the process as a tool to identify how they can deliver the best possible outcome to investors. They’re testing hypotheses about what works in investing, what doesn’t work, and how we should be managing our portfolios for the future.
The result of all this research helps us form best practices for investing. Rules and dogma that we can apply on our own. And coincidentally, the best practices have nothing to do with poring over financial statements to find the next stock to pop. Nor do they have anything to do with analyzing macroeconomic trends to project which way the trade winds will flow next. Thanks to the scientific method, we’ve determined that these strategies don’t work. They’re like just like bloodletting. This process is called evidence based investing.
The Results & Best Practices
Evidence based investing centers on delivering optimal investment outcomes. This is done by only using strategies that are vetted by the research & analysis. They’re only used if the statistics confirm it worked in the past, and we have reasonable assurance it will continue to.
So what are the actual results of all this research? What do the nerds suggest? To start us off:
- It’s not when you’re in the market, it’s how long you’re in the market
- No one can can consistently pick individual stocks and outperform an index after their fees (active management doesn’t work)
- Investment decisions should not be made based on what we think will happen in the future
These three points highlight the fact that no one can predict the future. No matter how much we analyze a stock, bond, or macroeconomic trend, the capital markets are based on human behavior. And humans are notoriously unpredictable.
Much of the current academic research also attempts to identify certain factors that outperforming securities have in common. For example, a researcher might want to test whether companies with a strong five year growth record tend to outperform the S&P 500 over the subsequent five years. If we could conclude that they do, this information might shape our investment philosophy.
While there’s not much of a case for companies with track records for growth, researchers have identified three factors that outperforming securities do tend to have in common: value, size, and profitability.
In general, value stocks tend to perform better than growth stocks over the long run. Small cap stocks tend to offer better risk adjusted returns than large cap stocks. And companies that exhibited high profitability in the past tend to continue outperforming in the future.
So what can we make of all this? How should this information shape our investment philosophies? How can we leverage the research to reach a superior outcome with our investing?
The best practices that come from the research will probably sound familiar:
- Be widely diversified. Since the research confirms that stock picking doesn’t work, our portfolios should be widely diversified to reduce security specific risk.
- Don’t time the markets. Even if you’re right in calling the next market crash, you’ll need to know exactly when to re-enter the market in order for a timing strategy to work. No one can do this successfully.
- “Tilting” your portfolio toward securities with factors that tend to outperform will probably boost your risk adjusted returns. Recent research suggests tilting toward stocks exhibiting small size, value, and profitability characteristics.
At my firm we help our clients implement these ideas by using funds managed by Dimensional Fund Advisors.
Feel free to reach out to me if you’d like to discuss how to do so in your portfolio.