On episode 30 of The Wealth Cast, Chas discusses the five tenets of evidence-based investing: markets work, diversification is your buddy, discipline is critical to your success, costs matter, and risk and return are related. He explains each, giving examples for how to apply them in your own portfolio management.
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I’d like to talk for a few minutes about the foundations of a good investment process. We believe that that foundation should be based on an evidence-based approach to investing. What I’m going to share in the next several minutes with you are five important tenets and fundamental concepts in evidence-based investing. And I’m going to start by first defining what does that term mean? What does evidence-based investing mean?
Evidence-based investing is simply a strategy that employs the academic evidence, the scientific evidence, for the pursuit of various strategies within a portfolio, and the use of various concepts in the portfolio structure. So I’m going to talk about five of those concepts / strategies over the next several minutes, and hopefully, by the end of this episode, you’ll have at least a clearer idea of what is involved. And there are some additional resources that we’re going to provide to you in the show notes, specifically a paper on evidence based investing, designed to be an introduction to the concepts that I’m going to discuss here, and more.
So let’s start with first, and perhaps the most fundamental concept in evidence based investing, which is that markets work—markets are efficient. The idea is—and the evidence shows—that information is processed very well by the capital markets, by the free markets. As investors receive additional information, that is quickly reflected in market prices, and what this means is—what the evidence supports—is that few if any, investors can systematically predict the movement of any security or market.
Really what this is, is an homage of the capital markets. There’s a lot of smart people out there, looking at securities all day long, trying to ferret out pennies, you know, trying to figure out how to take advantage of mispricings. And the fact that they do it so well is evidenced by the lack of professional investors’ abilities to identify mispriced securities ahead of time. The bottom line is that we as investors should invest, as if all the prices that we see in the marketplace are correct. Current market prices are as good an estimate of the correct price as any other estimate you may see, and much better than most.
The second concept to consider when you’re thinking about portfolio structure and basing it on evidence-based investing is that diversification is your buddy. Diversification is as close to a free lunch as you can get it investing. Quite simply because markets are efficient, and they work, and because it’s very difficult to predict the future of any individual security or market, diversification is a great tool. We diversify quite simply because we can’t predict the future. If you could predict the future, you would put all your money in one security—the best security out there. So diversification, in addition, is a very powerful risk-reduction tool.
The good news for investors is that you give up no expected return through diversification, but you do take less risk. Because the risk is associated with an individual security declaring bankruptcy, or having a crisis, or some sort of issue that causes the price to decline significantly. Diversification minimizes—doesn’t eliminate, but it minimizes—that risk.
The third fundamental concept is discipline. And when I talk about discipline, what I’m talking about is discipline in relation to market movements. You know, there are great times in markets when everything is going well, and there are poor times in markets when things seem to be going poorly. And what is lost sometimes on investors is that their behavior in those kinds of environments is much more important to their long-term success than the actual fluctuations in the markets themselves.
For example, in a market that’s declining, as prices decline, expected returns increase, all things equal. In other words, if you pay less for security, all things equal, and get the same cash flows you were expecting, the future return of that security is therefore higher. And so when prices are low, expected returns are high, and what happens is, very often, investors are scared out of securities, just when the future expected returns of those securities are highest. And then they buy securities on the other side of the equation, when the prices are high, but the expected returns are commensurately low.
So the way you avoid doing this systematically in your portfolio is through the process of rebalancing. So if you decide your portfolio is 50% stocks and 50% bonds, just to make it easy, and stocks have a really poor market, and now stocks represent 40% of your portfolio and bonds represent 60, you sell some bonds, and you buy some stocks. By doing so, what you’ve done is you’ve forced yourself to do what every investor knows they should be doing—which is buying low and selling high—at the margin, you have just bought some cheaply priced securities that because they’re cheaply priced, likely have higher expected returns going forward. You’ve just increased the expected return to your portfolio.
On the other side of the equation, if markets are doing very well, and your portfolio increases from 50% stocks to 60% stocks, you probably should consider selling some stocks to bring your portfolio back into that long-term, appropriate portfolio allocation of 50/50, and in doing so, what you’ve just forced yourself to do is sell high at the margin.
Now, of course, you have to consider taxes, and of course, you have to consider transaction costs, but the evidence shows that if you do this in a disciplined manner over a long period of time, it improves your ability to achieve your goals. Now, the caveat, of course, is that the original allocation has to be appropriate for the achievement of those goals. So you have to do some planning, you have to figure out how much risk you need to take, but once you’ve decided on that asset allocation, it’s the maintenance of that asset allocation that’s most important. It’s not predicting the future.
Let’s talk about number four now, and that is: costs matter. This may seem like a strange thing for an advisor to talk about, since we’re compensated, and that is a cost. But investors are very well served to sharpen their pencils and understand exactly what their cost structure is in their portfolio. Obviously, there are various sources of costs: there’s transaction costs, potentially, there’s bid and ask spread costs, there are management fee costs, there are mutual fund expense ratios. All of these things need to be understood, so that you can make sure that your portfolio is as efficiently invested as possible.
So make sure you understand your costs, and by the way, taxes are part of costs. If your portfolio’s invested in such a way that it’s inefficient from a tax standpoint, then that’s an additional cost you should be well aware of and considering as you evaluate your portfolio process.
The last thing that I’d like to mention is that risk and reward are related. The biggest mistake that investors make I think when they’re thinking about investment strategy is they think they’ve found an answer that gives them a return higher than what you’d expect for the given level of risk. In other words, there’s no such thing as a risk-free, high return investment. And I think that’s an obvious statement for most people, but there’s a lot of subtlety in-between, you know, a rational risk and a rational return, and then an irrational return for a given level of risk.
So what I would suggest, and what I’d like to see more people execute, is the idea that when you’re talking about an investment, you need to evaluate it in relation to the risk-free interest rates, the alternatives in the marketplace, and see, does this investment promise a return that seems out of line, given the amount of risk that I’m being told it takes? Of course that works both ways—if the return and risk are not well matched in either direction, in other words, not enough return for the amount of risk you’re taking, or too much return for the amount of risk you’re taking—those should both be conditions under which you reevaluate that investment.
And so what are sources of risk that you should be compensated for? Of course, there’s volatility risk—you need to be compensated for that. There’s the risk of default. There’s the risk of currencies in some investments. There’s the risk of illiquidity—the fact that you may not be able to sell it when you need to sell it. All of these need to be factored into the decision making process when looking at various investment alternatives.
So I’ve covered five really straightforward concepts—I think that are straightforward. We give more full treatment to these in our white paper on evidence-based investing that’s available in the show notes. But I’m convinced that if you focus on these five principles: markets work, diversification is your buddy, discipline is critical to your success, costs matter, and risk and return are related, then you’ll go very far, a long way towards having a successful investment experience.
And the last thing I’ll say is: Remember that a portfolio needs to be structured to drive the plan, and the plan is designed to get you to your goals. So think of always, the investment as the engine of the plan. And you don’t want to take more risk than you need to, to make that plan work. So make sure you have that in context and well articulated as you think about your investing future. Make sure you keep these concepts in mind. I’m available anytime to chat about them, send me an email, whatever is convenient for you.
Thanks a lot for listening, and I hope you found this helpful. Have a great day.
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