This is the second in a series of articles discussing various types of high-concept investment styles. This month we explain evidenced-based investing.
Investors and their advisors frequently are influenced by a variety of factors, ranging from news, rumors, biases, gut instinct, emotions (from exuberance to fear), marketing tactics, compensation models and business models. While any of these influences can lead to investment outperformance, they are just as likely to lead to flat or underperformance as well. Without real fundamental analysis, investing is just a combination of luck and conjecture.
However, the concept of Evidence-Based Investing is a more disciplined approach to asset management and securities selection. The practice involves analyzing past performance data with present economic circumstances. In other words, instead of using ,relationships or emotions to guide investment selection, EBI money managers utilize facts, logic and reason.
EBI involves extensive research to discover new factors and then test (and often reject) them against data from various investment time periods. Not only is the past used as prologue, but evidence-based investing practitioners also must pay careful attention to the current state of financial economics.
The primary goal behind evidence-based investing is to eliminate subjective factors that might influence decision making, such as some tidbit on the news or passage of new government legislation. An EBI portfolio starts with a carefully constructed asset allocation designed to meet a specific goal, with secondary considerations of lowering costs and tax liability. The evidence-based portfolio is regularly rebalanced to maintain its strategic asset allocation. Any new security introduced to the allocation must undergo disciplined analysis based on the current evidence for its fundamentals.
Generally, an EBI-constructed portfolio undergoes the following process:
While the evidence-based approach tends to be more technical than goal-oriented, it still relies on specific objectives. The strategy uses the most current evidence available to stratify securities by particular factors, such as size (small, medium or large cap stocks), style (growth, value or balanced) or timing (business life cycle or economic cycle).
The evidenced-based approach to investing is designed to replace guesswork with a disciplined, research- and analysis-based strategy that pairs past performance with the most current information available. It takes emotion and irrational behavior out of the investment equation by relying on a systematic analysis that combines strategic asset allocation, tactical security selection, global diversification, tax sensitivity and regular, disciplined portfolio rebalancing techniques.