What is Evidence-Based Investing?

by | | Investing

In this short video (<3 min) I cover three main principles of evidence-based investing.

In his book The One-Page Financial Plan, author Carl Richards provides a great anecdote that explains the concept of evidence based investing.

“A friend who also happens to be a doctor once told me that if he practiced medicine the way he’d been investing, he’d kill half the people he saw. When it came to his work, he would never prescribe a drug before reading peer-reviewed evidence to make sure all the trials went well—but when it came to investing, he assumed that he should be able to use his intuition to make good decisions. After all, he was smart and informed—how hard could it be to pick a few winners?

I suspect this reality applies to most if not all investors at some point in their lives.

But it doesn’t have to. In fact, there’s a better way.

I remember when I first started to learn about the science of investing. I was getting a professional designation taught by a professor at the University of Pennsylvania, and during one of the lectures, the professor introduced us to some of the work he’d been doing to help us approach investing in a rigorous, disciplined way. I remember thinking, “Where has this been my whole life?” It was like finding myself in a parallel universe.

Just as medical researchers have put their hunches to the test by beginning with a hypothesis, gathering data, doing blind testing, and getting their articles peer-reviewed and published in academic journals, so, too, have financial researchers been spending countless hours studying market performance. We don’t hear much about the science of investing because it’s, well, boring, but what they’ve discovered can be an excellent framework for building your unique investment portfolio.”

Principles of Evidence-Based Investing

Passive > Active

Invest in low-cost, passively managed funds that don’t try to “beat the market.” Over time, the majority of actively managed funds underperform, mostly due to their high fees.

Global diversification

Roughly 60% of the total stock market is US companies. That means the remaining 40% is from international and emerging markets. Some years US stocks will outperform international stocks and vise versa. Because of this, it’s appropriate to own both US and international stocks in your portfolio, to make sure you’re capturing the total return available in the market.

Factors can increase expected return

Over long periods of time, small company stocks historically have outperformed large company stocks, and value stocks have outperformed growth stocks. Having a slightly higher allocation to small and value stocks can increase your portfolio’s long term expected return.

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