Understanding Evidence Based Investing

November 01, 2017

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?
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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