What is Evidence-Based Investing? (EP.121)

0:28We all need to make smart decisions with our money. is celebrating its 40th anniversary this month. Our founder, Jeff Buckner, started PlanCorp because he wanted to give financial advice without necessarily selling a product. You know, back then, the financial services landscape of the 1980s was dominated with brokers and insurance companies. So Jeff establishing PlanCorp as one of the first fee-only fiduciary wealth management firms in the country was uniquely innovative, in my opinion. And to be fee-only, just simply means that the only revenue that the firm earns is directly from the clients for the advice and services provided, rather than any sort of commissions or other payments from outside parties.

1:10Decades later, I think a lot of us at PlanCourt feels like our success comes from this desire to do what's always best for our clients. It guides our investing, our planning, and even our service philosophies that have helped thousands of families establish legacies and make an impact for generations to come. So in honor of PlanCorp's 40th birthday, I'd like to celebrate and specifically focus in on PlanCorp's evidence-based investment philosophy. Here's how I describe 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.

1:57Embarking on this journey without a reliable map would be reckless. This map in the financial realm is what we call evidence-based investing. Evidence-based investing 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 fable beckon. History has shown that while markets are influenced by a myriad of factors, certain patterns and behaviors tend to repeat themselves. Evidence-based investing is the study and application of these patterns.

2:38Instead 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 evidence-based investing isn't just about cold, hard data. At its core, it's also a deeply human philosophy. It acknowledges our natural tendency towards fear and greed, optimism and pessimism. But by rooting decisions and 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 traverse the financial terrains before us.

3:21It'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, starting with the reliance on empirical 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're seeking to minimize the chance of approving a drug that is not beneficial to people's health or causes bad side effects.

4:04But 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 1 and type 2 error. The same trade-off occurs when evaluating which exposures to include in your portfolio. You can minimize type 1 error by owning a couple broad market index funds and never seeking further enhancements to your portfolio. Minimizing type 2 error, 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.

4:41The key is obviously to strike a good balance, but the thing I find most 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 1 or type 2 error. At PlanCorp, we know that each additional strategy has a diminishing marginal benefit, and in addition, the cost to implementing additional exposures at the portfolio level, not just at the fund level, will increase the uncertainty regarding the net benefit from its inclusion. For these reasons, we tend to be more concerned with implementing a bad idea than missing out on a good one, which for those who are keeping track, that sort of means that we prefer to lean towards minimizing type one error.

5:26But I think a lot of when people ask us questions about our evidence-based investing philosophy can be summed up with this idea that we tend to be more concerned with implementing a bad idea than missing out on a good one. Empirical research plays a crucial role in the remaining principles I'll highlight in this episode because in the grand theater of investing, where narratives often overshadow realities and speculation can be mistaken for strategy, evidence-based investing shines a spotlight on what truly matters. And at the heart of this approach lie two guiding principles, asset allocation and diversification.

6:04Decades of financial research have overwhelmingly shown that asset allocation is the primary driver of differences in return. And for all the amount of time that investors, including myself, spend studying and debating investment strategies, no single choice will have a greater impact on your 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.

6:49Diversification, in essence, is the acknowledgement of this inherent uncertainty. It's an admission that while we can't predict the future, we can plan for it. Now, 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 is going to disappoint you. Because being well-diversified means owning the winners and the losers. When one asset underperforms, another might be having its moment in the sun. And 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.

7:35One 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'll link to some additional resources on this topic in the show notes at thelongterminvestor.com, but concentrated stock positions typically emerge through employee compensation, inheritance, or just a couple really successful investments. But in all cases, a large individual stock position introduces unnecessary risk to the portfolio. Again, I'll link more to this in the show notes, but if you'd like to scroll through whatever podcast app you're using, you can go back to episode 63 titled, Should You Invest in Individual Stocks?

8:18Or episode 118 titled, Four Ways to Diversify Concentrated Stock Positions. The next principle of evidence-based investing I'd like to talk about has to do with the perils of market timing and performance chasing. Evidence-based investing suggests that consistently predicting market movements is challenging, if not impossible. And yet, market timing is a tantalizing concept. Investors all the time are seduced by the allure of easy, quick profits as they 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.

8:59Let's start with the simple acknowledgement that markets are unpredictable beasts. They're influenced by all sorts of factors from geopolitical events and economic indicators to corporate news and just overall market psychology. Predicting how all these elements will interact at any given moment is akin to forecasting next year's weather with pinpoint accuracy. It's a game of chance, not skill. Historically, markets have demonstrated their penchant for the unexpected. Black swan events, named after the once-presumed mythical bird, are by definition unpredictable. And yet, they have a significant market impact.

9:40The 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 underperforming the very funds they're investing in, meaning that they buy and sell the funds at the wrong time. And 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 one way or another.

10:25But there is an overwhelming number of people who want to make investments based on recent returns. And 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 performed poorly. For example, I've spoken to many individual investors as well as nonprofit institutions that wanted to make changes to their bond allocations in 2023 based solely on the bond market returns in 2022, which, by the way, was the worst year in bonds ever.

11:10And I could go really deep on this issue, but if you want to hear me go deep on this issue, why don't you go ahead, check out episode 109. I'll also link to it in the show notes at thelongterminvestor.com, because this is really just only the most recent example of investors wanting to own less of what has recently performed poorly and more of what has recently performed well. I mean, for the past several years, performance chasing tendencies has been even more prevalent when considering international versus U.S. stocks. And what's funny about this is I can clearly recall conversations from 2010 following the lost decade in U.S.

11:47stocks in which the S &P 500 had a negative average annual return for the prior decade. So many investors were eager to abandon their target allocation to U.S. stocks in favor for non-U.S. equities, especially emerging markets. But you fast forward to today, and the opposite is true. Now that U.S. stocks have trounced their non-U.S. counterparts, a lot of investors want to reduce their international and emerging market allocations. The allure of market timing, it manifests in a variety of ways and it will always persist. It's fueled by overconfidence and the inherent human desire for control. We crave narratives and we love the idea of being the savvy investor who saw it coming.

12:32It's just an irresistible story. But evidence-based investing nudges us to rise above these narratives and recognize the bigger picture. It encourages us to embrace humility and to admit that we can't foresee market twists and turns. The next principle is the importance of low costs. Imagine two runners racing a marathon. They start simultaneously, but one has a backpack filled with bricks. And as the race progresses, the weight drags that runner down, making each stride harder and harder, each mile more exhausting. By the end, the burdened runner is far behind his counterpart. In the world of investing, costs are those bricks.

13:15Evidence-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, the fees that you are paying for the mutual funds and ETFs 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 necessarily mean that you need to only utilize the lowest cost investments, because such a strategy would effectively mean only using index funds.

13:54And 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 exposures to factors that have historically higher expected returns or even geographic regions such as emerging markets that are just 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 a ton of evidence that higher costs eat away any benefit active managers provide. In episode 74, titled The Failure of Active Management, I go deep on this topic and look at a Standard & Poor's report that is released twice a year and shows the percentage of active managers failing to beat their benchmark.

14:44Every time this report comes out, you'll see 80 to 90 % of active managers fail to be a simple index. And yet, they charge much higher fees. Now, there are some extraordinary 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 is not worth it. However, the seductive allure of active management often blinds investors to these realities. There's a natural tendency for us humans to believe that if you are paying more for something, it must inherently be better. In many realms, this might hold true, but in the world of investing, it's counterintuitive.

15:27Here, paying more doesn't necessarily get you better performance. And as a result, evidence-based investing tends to emphasize low-cost or rules-based strategies that allow investors to keep more of their returns. The next principle I'd like to talk about is behavioral awareness. Behavioral finance is the fascinating intersection of psychology and finance, and it 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 game, These biases are hardwired into our psyche.

16:09Now, you may be asking, why is behavioral awareness so important to an evidence-based investing doctrine? Well, because investing isn't just about a numbers game. It's a psychological journey. Historical market data might suggest one course of action, but our inner fears and desires can pull us in a completely different direction. And often, these emotional detours can be costly. Evidence-based investing urges us to introspect, to recognize these biases, and to develop strategies to counteract them. It's about cultivating an awareness that while markets might be external entities, the responses they evoke are deeply personal and often not aligned with what is best for our finances.

16:53In essence, evidence-based investing isn't just about external market evidence. It's also about the internal evidence of our own behaviors. It's a dance between objective realities of the market and the subjective realities of our minds. The financial landscape is strewn with tales of fortunes made and lost, not just because of market movements, but due to the behavioral missteps of investors. That's why an evidence-based investing philosophy has to be acutely aware of our own behaviors. The last two principles of evidence-based investing are somewhat related. The first is regular rebalancing.

17:33Rebalancing 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 weakening ones, ensuring that the garden retains its intended design. And this is, in essence, the principle of regular rebalancing in evidence-based investing. Why is this principle so pivotal, you may ask? And I think first, we have to acknowledge a fundamental truth, that markets are dynamic entities.

18:16Asset classes don't grow at the same pace. A booming sector today could be tomorrow's laggard. And 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, then, might not align with their risk tolerance or financial goals. Enter rebalancing, which 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.

18:56It'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 also another layer to rebalancing, one that resonates deeply with the evidence-based investing philosophy, and that's discipline. The world of investing is awash with noise. Daily headlines scream about market highs and lows and 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 the antidote to this. It's a ritual that forces investors to buy low and sell high.

19:37often contrary to prevailing market sentiments. Which brings me to the final evidence-based investing principle I'd like to cover in this episode, which is the importance of staying 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. After all, our ancient ancestors, when they heard a rustle in the bushes, they just ran. They ran out of fear. They didn't have the time to calculate the probability that the noise in the bushes was a lion versus the probability it was the wind.

20:19Taking the time to think about it posed too much of a risk of being pounced on, and so it's just 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, it remains deeply ingrained in us, and that makes it tough not to react when we get spooked by the stock market. We never know when or why the next correction or bear market will happen, but what we do know is that market downturns happen on a regular basis, and rather than trying to predict the timing or the cause of the next downturn, you're better off planning on historical levels of volatility persisting over time.

21:00That means investors must be willing to lose money on occasion, and sometimes a lot of money, just to earn the average long-term return that attracts most people to stocks in the first place. But the good news is that you can reduce the chance of a permanent loss by agreeing to stay invested over a long period of time. Now, I don't think staying the course is about blind rigidity. I think it's more about informed perseverance. At PlanCorp, we make investment decisions within the context of a multi-decade time horizon. Not only do we know that markets will regularly experience downturns, but we accept that strategies will fall in and out of favor.

21:39The long term feels like an eternity to live through in the moment, but the most basic parts of financial theory look pretty darn good when you allow them time to work. So investors who remain disciplined and stay the course will be rewarded over time. As always, you can find the resources mentioned and detailed show notes by visiting thelongterminvestor.com. And if you enjoyed this episode, please consider leaving a review wherever you're listening. That makes this episode as well as the overall show easier for other listeners to discover. Thanks for listening. And until next time to Long-Term Investing.

22:16Thanks for listening to the Long-Term Investor podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.