What is evidence-based investing?
Evidence-based investing (EBI) is an investment philosophy and strategy built on decades of historical data and research. The research shows that asset allocation, usually via low-cost index funds, increases the probability of outperforming active or individual stock-picking strategies over the long term.
For example, in a report from October 2021, Morningstar found that most active managers (stock pickers) failed to beat their passive benchmarks in the prior year and only 11% of large-cap fund managers outperformed the index over a 10-year period. (1)
In other words, the indices outperformed active managers 89% of the time over a 10-year period.
89% odds are pretty good.
Evidence-based investing proponent Larry Swedroe found that 20% of active managers in 1998 beat the index or were generating statistically significant alpha. In October 2020 he found that the percentage was reduced to 2%. Only 2% of active managers generated statistically significant alpha.
Take the 98% odds.
Swedroe goes on to explain that the 2% who beat the indices only do so before taxes. Taxes, such as capital gains taxes, are an added expense that reduce overall returns. If you include the tax expenses from those active managers, then the percentage is reduced to “probably more like 1%” who beat the index, he says.(2)
Warren Buffett’s billionaire investor partner Charlie Munger states, “The finance industry is 5% rational people and 95% shamans and faith healers”. (5)
In October 2021, Financial Times global finance correspondent Robin Wigglesworth stated that indexing has slowly taken over the investing world because of two things: cost and performance. Index funds expense ratios are extremely inexpensive, around four basis points or .04%. “And then it’s just the performance side, which I think a lot of people still don’t really realize, that in the long run, the index beats the vast majority of professional money managers across virtually every major asset class. In areas like equities, we’re talking 90%.”(1)
So even though all this data shows indexing and asset allocation works better, why is active stock picking still as popular as ever? Humans are storytellers and we all love telling and listeningto a good story. The story of investing in indices is pretty boring compared to the hot stock picks, renegade startup companies, derivative strategies, and financial news entertainment a la Jim Cramer.
Does the evidence still support that low-cost indexing outperforms active management when fees and expenses are considered? “Yes. Very much so… over any rolling 10-year period that you care to look at, around 10%-15% of managers manage to beat the index, and that’s basically what you’d expect from just random chance. A lot of investors actually do worse than the markets not just because they try and pick hot stocks or hot fund managers, it’s because they typically bail when something goes wrong or they jump on momentum.”(1)
JP Morgan found that over the 20-year period (2002 – 2021) the S&P 500 had an annualized return of 9.5% while the average investor had an annualized return of just 3.6% (62% less). (4) It can be hard for investors to 1) Design or choose an investment strategy and 2) to stomach and stick with the strategy or plan during volatile markets. Advisors can help with both.
The interviewer goes on to ask Wigglesworth: What’s the conclusion here? It’s still certainly very clear, would you say, that the concept of market timing does not work, that the problem with market timing is that you have to be right twice — you have to be right going in and then on an exit strategy, you have to be right going out? And the probability that you’ll be able to do that consistently over time — not once, but consistently over many, many years — is very small, at least the academic evidence indicates it’s very small. Am I correct?
Wigglesworth: That’s right. And frankly, even practically as well, and I’m sure you’ve talked to tons of investors that will admit this willingly, that they might be phenomenal security selectors, they might be even great at constructing a portfolio, that market timing is essentially a fool’s errand. And even pedigreed active managers I’ve spoken to admit that that is something they do extremely wearily just because the data and the history is pretty grim. And I think every big active manager has some sort of horror story about sometimes getting a call right, but the timing horrifically wrong, or sometimes getting a call wrong, but they just got lucky on timing, for example. So I think it is one of those perils. As Bogle used to say, it’s time in the market rather than timing the markets that matters.(1)
An advisor using an evidence-based investing strategy accepts that he or she will not be in the 2% of stock pickers that consistently beat the market over time. That’s extremely difficult and rare. Instead, they love taking the 98% odds. These advisors admit they don’t have a crystal ball showing how certain stocks, asset classes, or funds will perform in the immediate future, and they don’t pretend as if they do. This humility allows them to build an investment strategy based on data, not on gut feelings or best guesses, that has the best chance of delivering stable long-term returns. And this humility allows them to focus on the things they can control. Think: dollar cost averaging for wealth building and tax-efficient withdrawals for retirement planning. Think: preparing for a market downturn as if it will happen tomorrow, instead of predicting a downturn in “x” months or years. Think: keeping costs, fees, and taxes low.
Evidence-based investing shows that diversification is your friend. It’s been said that diversification is as close to a free lunch as you can get it investing. Investors do not give up any expected return through diversification, but they do take less risk. Individual securities have individual risks, like declaring bankruptcy, experiencing a crisis or an issue that causes a steep price decline. Think GE, Enron, Boeing, the list goes on. Diversification minimizes, but doesn’t eliminate, this risk. It’s important to note that systemic or market risk still exists here, though. And that’s okay.
The stock market is the opposite of a casino. The longer you play in the stock market, the higher the odds you win. The longer you play in a casino, the higher the odds you’ll lose because the house wins based on pure probability. It’s just the opposite in the stock market. The longer your time horizon, historically, the better your odds are at seeing positive outcomes. (3)
What is survivorship bias? When analyzing and ranking the performance of mutual funds, only funds that currently exist, i.e., the ones that survive, are included in the analyses. They do not include the funds that do not survive and are no longer in existence. And these funds no longer exist because they performed poorly and usually the worst of the bunch. Therefore, the studies show better numbers than reality. They suffer from an upward bias in returns, which is known as survivorship bias. The studies should include the non-survivors in the analysis to be more accurate.
Dimensional Funds found: For actively managed US equity mutual funds over the period from 1991 to 2020, survivorship bias overstates the median fund alpha by 0.60% per year: The median fund alpha is –0.84% per year among surviving funds compared to –1.44% per year among both surviving and non-surviving funds. (5)
When building your wealth or retiring on it, try to place the odds in your favor. Evidence-based investing can help show you the way.