What we mean by evidence-based investing

Here at Carbon, we are firm advocates of evidence-based investing. But what exactly does that mean?

Well, the financial services industry is full of people making promises they can’t keep – promises about ‘beating the market’, about picking the best stocks, about market timing and about guaranteed returns.

Much as these offers can be tempting for those of us looking to grow our wealth and adequately fund our retirement, they don’t really stand up to scrutiny.

The truth about beating the stock market

The truth is, markets are hard to beat consistently. Picking stocks based on the view that prices are wrong is like betting on the horses. It can go either way. Even the professionals aren’t very good at market timing. And as for guarantees, think about this: if there were no risk to investing, why would there be a return?

Evidence-based investing is an approach grounded in empirical research and the long-term observation of markets and how they work. This is not an approach based on guesswork or gut feeling or hunches or the idea that any single person has some magic formula for seeing into the future. It is an approach based on verifiable facts and observation.

In a world of slick marketing, spin and hype, the idea of respecting evidence is frequently undervalued. As the great Scottish philosopher David Hume once said, a wise man proportions his belief to the evidence. The danger of doing otherwise was highlighted by the fictional detective Sherlock Holmes, who said if you theorise before you have the data, you begin to twist facts to suit your theories.

The truth, supported by overwhelming evidence, is that consistently beating the market over the long term is extremely hard. Winning fund managers don’t tend to repeat year-to-year, and even the very few who do, tend to capture any additional returns for themselves by charging high fees for their superior skills.

So, why are markets so hard to beat consistently?

• The first reason is competition. Security prices in global markets represent the aggregated wisdom of millions of buyers and sellers, each with their own views of the right price for each stock. New information, like earnings reports or economic data, are factored into prices instantaneously. The ever-increasing speed of information flows, and the sophistication of trading systems mean getting an edge is tough. And doing this consistently, day after day, is nigh on impossible. Of course, there will inevitably be mistakes in prices. But can you spot them in advance, not just today, but every day? Doubtful.
• The second reason is arithmetic. If one investor has a strong feeling about an individual stock being mispriced and profits from buying it, there must be a loser on the other side of the trade. One conventional investor can only win at the expense of another. So investing this way, by trying to outguess the market, becomes a zero-sum game.
• The third reason is cost. Making big bets against the market doesn’t come cheaply. There’s the cost of all that research on individual stocks, the cost of trading, the cost of falling in love with individual stocks or sectors and paying too much for them. Most of all, there’s the cost of paying the big salaries and bonuses that the managers demand. So just beating the market isn’t enough. You must beat it by a big enough margin to cover your costs. And you must do it over and over. This means for the end investor, using these traditional funds ends up being even worse than a zero-sum game.
• The final reason is news. Even if your view on a stock’s inherent price is rock solid, based on today’s information, what if the news changes tomorrow? A company’s advantage might be undone by new technology (think Kodak) or a disaster (think BP) or a governance crisis (think VW). Predicting prices correctly implies you can predict tomorrow’s news headlines. Do you know anyone who can do that?

What does the academic evidence tell us about traditional money management?

There are dozens of studies illustrating the difficulty money managers have in outperforming the market consistently:

• Professor David Blake at Cass Business School in London has led an ongoing study^[1] into the performance of equity funds in Britain and the US. It found that very few funds beat the market over the long term on a risk- and cost-adjusted basis, and that even those funds effectively claw back from investors any additional returns they generate by charging higher fees.
• Professor Eugene Fama (a 2013 Nobel laureate) and his research partner Kenneth French studied the performance of more than three thousand US mutual funds over 22 years.^[2] They found that on average the funds lagged the market by about the fees they charged. While some individual managers undoubtedly did outperform, it was almost impossible to discern whether this was due to skill or luck.
• S&P Dow Jones Indices regularly publishes a report (Standard & Poor’s Index Versus Active or ‘SPIVA’) which compares the returns of traditional managers against indexes across different time periods and asset classes in various markets around the world. The overwhelming pattern is that actively-managed funds tend to underperform their benchmarks over short and long periods and funds that do outperform over some periods do not do so over others.

If you’re new to the idea of evidence-based investing and would like to learn more, why not get in touch? We’d be happy to answer any queries you may have.

^[1] New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods, by Blake, Caulfield, Ioannidis & Tonks, June 2014.

^[2] Luck Versus Skill in the Cross Section of Mutual Fund Returns, by Fama, Eugene F. and French, Kenneth R., December 2009.

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