A Wealth Advisory Practice

More Thoughts on Evidence Based Investing

We do not prescribe to the idea of Evidence Based Investing (EBI) as it is typically marketed. This is not because we think investors should be passive or active in their portfolio management decisions, but rather because it’s underpinnings are not backed by economic fundamentals nor fully represent the entire wealth of evidence generated over the years.

It is our view that EBI is typically centered around the idea that markets are informationally efficient and it is very difficult to beat the market. Research behind EBI suggests that there is no evidence of persistent skill and that the best way to invest is in exposure to various risk factors. We would agree that this is a very attractive position. However – we believe the underlying argument is not as robust as we would prefer. Some thoughts on the matter:

  • There is no underlying economic or asset pricing model that explains these risk factors. One can test the market for efficiency or how asset prices are set but not both at the same time. EBI is focused on market informational efficiency with no test for how prices are set (i.e. economic efficiency).

  • There is also Nobel-prize winning research that argues the markets are too volatile to be efficient, at least from an economic or Pareto efficiency manner. Pareto efficiency is an economic state where resources are allocated in such a way that any change would make one person better off at the expense of another person.

  • There is no testable view as to whether risk is derived from fundamentals, from investor behavior, or some combination of the two.

In other words EBI is relying purely on empirical research to tell its story. However, back in 1993, Fischer Black complained about the issue of observational (i.e. empirical) research [1]:

With enough data mining, all the results that seem significant could be just accidental

To bring this home consider the 2005 paper by Mr. Ioannidis titled Why most published research findings are false [2]. Here’s the summary from Michael Mauboussin’s book The Success Equation [3]:

Ioannidis, who has a PhD in biopathology, argues that the conclusions drawn from most research suffer from the fallacies of bias, such as researchers wanting to come to certain conclusions or from doing too much testing. Using simulations, he shows that a high percentage of the claims made by researchers are simply wrong.

Therefore we think a more pragmatic approach to investing that accepts that markets (just like academic research) can be influenced by behavior and can stray from reasonable definitions of fundamental value. While this view puts at risk of market timing, we would rather have a view of the state of capital markets. We accept that investing can be like riding a roller coaster, but we prefer not to be blind folded.

[1]: Fischer Black, Beta and Return, Journal of Finance 41(3) (1986) 529-543.

[2]: John P. A. Ioannidis, Why most published research findings are false, PLoS Medicine 2(8) (2005) e124.

[3]: Michael Maouboussin, The Success Equation, Harvard Business Review Press, 2012, 41-42.