Understanding Evidence Based Investing

November 01, 2017

Barry RitholtzRitholtz Wealth Management is holding its 2nd annual Evidence-Based Investing Conference on Nov. 2 in New York. With keynotes from the likes of Vanguard’s president Tim Buckley and AQR Capital Management’s Cliff Asness, the event is meant to spark a conversation about what drives investing decisions, and how a focus on facts can lead to better outcomes. Barry Ritholtz offers us a preview of what evidence-based investing is all about.

ETF.com: What is evidence-based investing? How different is it from factor investing?

Barry Ritholtz: Factor investing is a form of evidence-based investing.

When we rolled out the first conference, a lot of people's response was, “Isn't all investing evidence-based?” Our response was, “You’d think so, wouldn't you?” But it turns out lots of investing is emotional, reactionary, noise-driven investing.

Every year, Dalbar comes out with a study that shows how well the average investor has done. And the average investor has done poorly.

Not only do they not meet the benchmark, they have a tendency to not even beat their own holdings, which sounds crazy, but it means they tend to buy ETFs and mutual funds after they've had a big run-up, and they tend to sell them after they've had a big move down. They don't even get the benefit of what they actually own.

ETF.com: Evidence-based investing is essentially the opposite of behavioral investing?

Ritholtz: It's making decisions based on things that we know are factually true.

Some of evidence-based investing is, “We know at the root that people aren’t really rational, profit-maximizing machines, despite what a lot of economic theories suggest.” So a big part of evidence-based investing is understanding where we get in our own way.

The thing we really like about factor-based investing is historically the data shows that if the holdings you have have a bias toward small-cap, toward cheaper valuation, toward high quality over long periods of time, you’ll likely do better than the market, because history shows us that stocks with those characteristics, on average, statistically tend to outperform the benchmark.

That sort of data analysis is part of what evidence-based investing is. And there are many flavors of it; it's not just factor investing.

ETF.com: Is the goal to generate persistent alpha where active managers are failing?

Ritholtz: The assumption that's automatically built in to a lot of the world of investing is, “I must pursue alpha; I must beat the market.” To do that, I'm going to take more risk or pay a little more.

One of the first steps in evidence-based investing is asking these simple questions: Why are you investing? What goals do you have? Do you need to assume more risk to achieve your goals?

We all want to do better than average, but sometimes you have to say, “Here's beta; that's a sure thing. All the data says odds are that very few people do that over three years; even less do it over five years.

The trade-off often is that you're assuming more risk, more volatility, and the odds are that you're not only not going to get alpha, you're not even going to get beta. Evidence-based really means unpacking questions and asking really broad, fundamental thoughts on what we’re really looking for.

ETF.com: Increasing availability of data is key for evidence-based investing, right? Is there a point where too much data actually makes it harder to make good investing decisions? Information overload?

Ritholtz: I don't consider news or commentary or economic releases to actually be data. That’s noisy stuff. To me, data is when we go out and look at what’s actually happened in the market and see if we can sift through the numbers to figure out something of value. Information overload is a legitimate problem. But that has to do more with people's media diet than it does with actual data.

But that’s an interesting question when we talk about valuation. And that's a perfect example of where evidence, and the ability to put stuff into context, really makes a big difference. Stocks are almost never at fair value. They tend to either be cheap and getting cheaper, or expensive and getting more expensive. They're at fair value briefly as they carom by in one direction or another.

My two favorite examples of this: In the 1970s, the stock market was cheap. It started out with a P/E ratio of about 12. By the time we got to 1982, the P/E ratio on the S&P 500 was single digits.

That sounds fantastic. You should have owned stocks throughout the 1970s—except for the fact that the risk-free 10-year Treasury was yielding 10%, and inflation was almost that high.

 

So if you held stocks when the P/E ratio was cheap, you weren't rewarded for that. If you look at the period that followed the 1970s, the secular bull market that lasted from 1982 to 2000, stocks started out cheap and then got more and more expensive.

By '92, '94, '95, stocks were no longer cheap; in fact, they were above fair value. I very specifically recall 1996, when a ton of people came out and said, “This market is very expensive.” That absolutely did not help you as an investor, because the market that was expensive in '96 went up high double digits for the next four years.

I'm not going to argue by most metrics that stocks aren't expensive, but stocks are often expensive. Take the CAPE ratio, which has been above its average over 90% of the time for the past 30 years.

If you looked at the CAPE, and got out of stocks, you missed at least 20 years of market gains out of those 30 years. Evidence-based investing says you can't just look at the numbers in abstract. You have to understand what it means in context.

ETF.com: In an evidence-based approach, how do you know if it's working? Do you need a benchmark?
Ritholtz:
There are a few benchmarks, and I think people sometimes, again, don't necessarily use context. Everybody uses the S&P 500, but that's only a valid benchmark if you're looking at large-cap and in the U.S.

Another benchmark is thinking about the purpose of this investment. If you’re a pension fund, do you have certain obligations you have to meet? That's a different type of benchmark. A third benchmark is something that's more narrowly carved out versus the broad index. It depends on what your particular portfolio is.

We have to have benchmarks so we know if we're getting our money's worth when we're paying up for the attempted alpha. Our tendency is to believe the most optimistic projection while ignoring the factual data on recent performance. That's not evidence-based, that's wishful thinking. And you'd be surprised at how many billions of dollars are managed under wishful thinking.

ETF.com: This is your second year holding this conference. What core message do you hope to get out there?

Ritholtz: That most of Wall Street has been driven by myths and rumors and heuristics and people's thoughts and feelings. It hasn’t been much of a data-based approach, but we've seen the rise of the quants and factor-based investing, and things that are much more rigorous, more rules-based, more evidence-based.

You could make an argument that the rise of companies like Vanguard and BlackRock has certainly led us to a point where people have been participating in index-based investing because they don't think they can generate alpha, they don't think it's worth the cost, or they don't understand why there should even be any alpha in their overall portfolio. That general move seems to be affiliated with the idea of evidence-based investing.

I've accused the mutual fund industry of waving shiny objects in front of investors—Hey, this guy's up 18% this month, you should own this fund—and that’s where evidence-based comes is.

If he's up 18% this month, aren't we due for some mean reversion? How does this fund fit into my overall portfolio? How risky is this?

You have to answer these questions and understand what the upside and downside is going to be.

Contact Cinthia Murphy at [email protected]

 

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