A Wealth Advisory Practice

Evidence Based Investing

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Evidenced based investing (EBI) comes from the medical profession and evidence-based medicine (EBM). EBM is a way to practice medicine based on processes and guidelines that have been developed using sound research. EBM term was popularized in the late 1980s and early 1990s.

As for investing, the term is focused on investment best practices based on financial research. It is about designing investment strategies (remember – processes and guidelines) based on empirical research. The focus however of EBI seems to be mostly to debate the benefits of passive investing versus active investing.

From our perspective, the idea of using sound empirical research to support portfolio management decisions is attractive. However, EBI has its faults just like EBM. Consider the 5 criticism of EBM by Cohen, Stavri, and Hersh [1]:

  1. EBM is based on empirical research, which is not required to be centered on sound philosophical science or medicine.

  2. EBM is too narrowly defined and often not helpful enough to practitioners.

  3. EBM isn’t evidence based.

  4. EBM benefits to individual patients is limited.

  5. EBM disrupts the independent nature of the patient and doctor relationship.

These criticisms in one way or another are applicable to EBI. Consider the first criticism. Most EBI practitioners won’t admit it but there is no fundamental economic basis behind the empirical evidence. Therefore there is a case that much of the empirical research is just data fitting and/or backtesting historical data.

As for the third criticism and whether it is evidence at all consider the idea of whether the research is stating that there is the evidence of absence or whether there is just an absence of evidence. Empirical research often takes the absence of evidence (not very interesting) and conflates it with evidence that something is absent (interesting).

Take the «evidence» on investor skill and investment performance. Studies showing the inability of investors to consistently outperform a passive benchmark over time doesn’t necessarily mean an investor doesn’t have skill (based on the type of research typically presented). More likely it is the confirmation of the competitive nature of investment capital chasing those investor’s who do have skill.

So we would conclude that passive investing makes sense just like EBI would – but not because there isn’t skill but rather that the capital markets are competitive and those with skill are sought out to the point where they can no longer provide above-market (i.e. what a passive would earn) returns. We like our position better because it doesn’t conflate the absence of evidence with the evidence of absence.

Given our philosophical agreement with the criticisms of this style of using evidence, we don’t utilize Evidence Based Investing as a cornerstone of our investment process.

[1]: Aaron Michael Cohen, P. Zoe Stavri, William R. Hersh, A categorization and analysis of the criticisms of Evidence-Based Medicine, International Journal of Medical Informatics 73 (2004) 35-43.