Welcome to the next instalment in our series of evidence-based investment insights; What has evidence-based investing done for me lately? To check out the rest of the series, click here.
In our last piece, Factors that figure in your evidence-based portfolio, we introduced three key stock market factors (equity, value and small-cap) plus a couple more for bonds (term and credit) that have formed a backbone for evidence-based portfolio construction.
Does this mean we know everything we need to, to build ‘perfect’ portfolios? Hardly! As Eugene Fama has explained: “You should use market data to understand markets better, not to say this or that hypothesis is literally true or false. No model is ever strictly true. The real criterion should be: Do I know more about markets when I’m finished than I did when I started?”
Continued inquiry has found additional market factors at play, with additional potential premiums (which also seem to result from accepting added market risk, avoiding ill-advised investor behaviours, or both). Two of the more prominent among these are profitability and momentum:
- The profitability factor – Highly profitable companies have delivered premium returns over low-profitability companies.
- The momentum factor – Stocks that have done well or poorly in the recent past tend to continue to do the same for longer than random chance seems to explain.
A closer look at newer factors
Before we get ahead of ourselves, let’s discuss a few caveats.
- Wet paint warning – While these ‘new’ factors may or may not have existed for some time, our ability to isolate them is more recent. As the ink still dries on the research papers, some among the evidence-based community are still assessing their staying power.
- Cost versus reward – Just because a factor exists in theory, doesn’t mean it can be implemented in real life. We must be able to capture an expected premium without generating costs beyond its worth.
- Dueling factors – Sometimes, it can be difficult to build one factor into a portfolio without sacrificing another. Benefits and tradeoffs must be carefully considered at the fund level as well as for your individual goals.
As a result, opinions vary on when, how or even if profitability, momentum, and dozens if not hundreds, of newer potential factors should play a role in current portfolio construction. As Fama has expressed: “There’s one robust new idea in finance that has investment implications maybe every ten or 15 years, but there’s a marketing idea every week.” We would be happy to speak with you individually about our evolving approach. To help you assess whether they may make sense for you, let’s explore how to think about investment information.
Investment information: A double-edged sword
As time marches on, relentless questioning from scholars and practitioners alike has been essential to evidence-based investment theory and application, dispelling illusions and laying the foundation for the insights we now routinely harness.
Similar inquiry must continue to pave the way to future improvements. But one need only glance at daily headlines to notice a never-ending stream of ideas from competing, often conflicting voices of authority. While being informed is helpful, information overload can do as much harm as good to well-intended investors. Even when the news is solid (which is never a given), hyperactive reaction can strip away all the advantages of an enlightened investment approach.
Investment reality: Choose your allies carefully
So, how do you know what to heed and who to ignore? This is where we believe an evidence-based adviser relationship is critical to your wealth and your wellbeing. Calls to action that erupt overnight based on scant evidence and concentrated events are unlikely candidates for building into a durable investment discipline. As we outlined in The essence of evidence-based investing whenever we assess the validity of new and existing market insights, we ask pointed questions that can take years to resolve:
- Have the results been replicated across factors, over time and around the world?
- Is there robust analysis, not only from industry insiders, but from disinterested academics?
- Has it survived extensive peer review, if not unscathed, at least free of mortal wounds?
Your take-home
By considering each new potential factor, according to strict guidelines, our aim is to extract the diamonds of promising new evidence-based insights from the considerably larger piles of misleading misinformation. We feel you are best served by heeding those who take a similar approach with their advice. Next, we turn to a factor we have mentioned, but have yet to explore, even though it may be the most influential one of all: you and your financial behaviours.
Continue exploring the rest of the evidence-based investment insights here.
