This article is provided by the independent fee-based investment and wealth management firm Private Capital Limited.
The Evidence Behind the Term:
Private Capital has a reason for calling its investment strategy for building lasting, long-term wealth "Evidence-Based Investing (EBI)". We could use many other terms instead: Structured (increasingly popular), Low-cost (definitely so), Passive (sometimes), Smart Beta (perhaps), Indexing (close, but)... the list goes on. But because evidence is fundamental to what we do, we believe it should also be fundamental to how we describe what we do.
That said, there is a vast amount of evidence to consider, and some so-called findings seem contradictory. How do we know which evidence to take seriously? Which are false leads?
Evidence-Based Investing: An Endless Story
First, it is worth noting that academic inquiry is never entirely final, nor absolutely applicable to our research. As the University of Chicago finance professor and Nobel laureate said: "You should use market data to better understand markets rather than simply stating that this or that hypothesis is true or false." No model is absolutely correct. The real standard should be: "Do I know more about the markets compared to when I started?"
Nevertheless, when evaluating the validity of a large body of academic evidence, there are still many important qualities to look for.
A Fair Perspective – Ideal academic research does not start from a point to prove something, but explores interesting phenomena without any agenda and reports results. Then it is up to our practitioners to apply these useful findings.
Strong Data Analysis – Analysis should avoid weaknesses such as data cycles that are too short or sampling ranges that are too small; survivorship bias (referring to the omission of returns from funds that lost money during the analysis); comparing apples and oranges benchmarks; or simply outdated mathematical errors.
Reproducibility and Replicability – Results should be repeatable in additional studies across multiple environments and timeframes. This helps prove that results are not just random luck or "data mining." As described by AQR fund manager and founder, "If a researcher finds an empirical result simply because they interrogated the data until it confessed, people would not expect it to work outside the interrogation room."
Peer Review – To ensure the above work is done as required, scholars should publish detailed datasets, methods, and findings in reliable academic journals or similar forums so that qualified peers can judge their work, agree that the results seem valid, or otherwise reject them.
Alternative: The Stupidity of Data
If our emphasis on deep and diligent peer review does not sound truly applicable to you and your tangible wealth, think again. When erroneous conclusions are inappropriately applied, the results can lead countless investors astray, losing real money, which is consistent with people's views on lies, damned lies, and statistics.
Think of this excellent report by journalist John Bohannon: "I Fooled Millions into Thinking Chocolate Helps Weight Loss. How I Did It." The evidence-based trap happened to occur in the medical industry, but similar lessons apply to finance.
Bohannon first conducted a flawed "study" as an obvious example of poor research. He intentionally used a trivial dataset with only 15 participants in a single trial, then rigorously probed the obtained data to reach a technically accurate but practically meaningless conclusion: eating chocolate helps weight loss.
Next, Bohannon leveraged his familiarity with the scientific publishing industry to submit his research to several journals with poor reputations during the screening process. Although Bohannon fully exposed many weaknesses of the study, he noted that his paper "was published less than two weeks after (our) credit card was charged." Subsequently, he and his partners launched a massive PR campaign against a global media outlet, which obviously cared more about publishing exciting news summaries than verifying the authenticity of relevant sources.
His final exhibition headline tells us the ending of the story. The overwhelming coverage on TV, web, and print media implied to audiences worldwide that they might want to lose weight through chocolate. There was erroneous evidence, no conclusion.
Advantages of Peer Review
The point is not to treat all evidence as forged. The key is that substantive, meaningful peer review remains a crucial component in distinguishing genuine academic evidence from loose work with excessive workload, which often frequently makes headlines. Peer review also allows scholars to reference and build upon their colleagues' best work, thereby deepening and expanding collective insights on important topics over time.
This is why we are most interested in applying a set of ordered (if never definitively established) principles to guide our practical, evidence-based investment strategies, which have withstood the test of time and the test of academic peer review.
The Basic Role of an Advisor: Distinguishing Fact from Fiction
As evidence-based advisors, we constantly examine work presented to the public, fill in due diligence that may have been missed, and convert results into insights aimed at helping investors view the full picture appropriately.
Among all the ways we invest, which ones best meet clients' personal interests and financial goals? Equally important, which factors are more likely to distract us? The evidence-based answers to these key questions explain why we value quality so highly (e.g., fund structures similar to index asset classes, cost management, patient trading, and global market risk exposure (beta)). This is also why we advise against trying to chase or flee current market trends or picking popular stocks, even though seemingly learned leaders seem to always suggest doing so.
This is Evidence-Based Investing. It is the essential difference between establishing a manageable investment strategy that reflects your personal goals and succumbing to chaotic, nerve-wracking speculation. Private Capital chooses evidence.
