Where is the evidence? – Injecting some science into your investment approach

As Gordon Gekko reminds us in the film Wall Street, investing is a ‘zero sum game’.  On average, half of investors outperform the market and half underperform.  However, when you add in the costs of investment, outperformance starts to look an increasingly difficult challenge.

Traditionally, investors have attempted to solve this problem by searching for those investments or managers that consistently beat the market despite their higher costs.  Unfortunately for them, there is very little information available to help with this except to look at past performance.  Unlike studying the form at the horse races, the evidence shows us that this strategy is close to random in terms of its effectiveness in picking the best managers for the future.

Capture

So, what are the alternatives?  This chart shows us that a lower cost ‘passive’ investment strategy will deliver us a return very close to the market average. As a result we can say that this approach is much more likely to give you a successful investment experience than the higher cost ‘active’ strategy.

But can we do any better?

To adopt the passive strategy is to accept that you will always slightly underperform by the cost of your investment (albeit these costs are relatively small).  It is not human nature to consider ‘underperformance’ as a success and this is a common criticism of passive strategies as a whole.

There is evidence which proves that within markets there are specific sectors where there are higher risks which have historically provided a ‘premium’ return over the average market.  There is an understandable economic rationale for why these companies are riskier and therefore why we should expect a higher return from them.  Furthermore, specific exposure to these companies can be captured in a manner which does not impact heavily on costs and can be achieved without sacrificing diversification.

The evidence for these market premia is backed by Nobel prize winning research.  Nevertheless we do not stake the house on it.  We include tilts within our portfolios which are sufficient to ensure that where there is a premium, our clients are there to capture it. Where there is not, they do not suffer a rocky ride for no reason.

A robust investment solution should be a given.  You wouldn’t use a medicine which hadn’t been scientifically tested for evidence that it works and why it works.  We believe the same should apply to your investment portfolio.

Adopting an evidenced based investment approach has many more advantages than the few briefly mentioned here.  We would be delighted to talk to you about our investment philosophy, how we manage money and how this fits in with our role as personal finance directors to our clients – Why not get in touch?

 

 

 

Posted by:
BDB Financial

Published:
April 24th, 2015

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