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.


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