As an investor, you’re inundated with information about many different investment strategies, from day trading and stock picking to long-term value investing. The options can be overwhelming.
There’s one approach that’s supported by compelling, peer-reviewed research. It’s appropriately called “evidence-based investing.”
Evidence-based investing combines data-driven research with a long-term perspective.
Here’s why it’s likely to be an intelligent choice for you.
What is Evidence-Based Investing?
Evidence-based investing (EBI) (also known as “passive investing”) is an investment approach that emphasizes making decisions based on empirical evidence and rigorous research rather than relying on speculation or market timing.
It’s grounded in the principles of finance and economics and is designed to minimize the impact of emotions and biases on investment decisions.
EBI seeks to identify investment strategies with a strong historical track record of success supported by academic research.
Benefits of EBI
There are many benefits of EBI. Here are the main ones.
Mitigating Emotional Bias
Evidence-based investing mitigates emotional decisions by relying on data and research to guide investment decisions rather than emotions like fear and greed. When investors make impulsive decisions based on emotions, it can often lead to poor outcomes.
EBI uses empirical evidence and rigorous research to make informed decisions grounded in finance and economics.
Long-Term Perspective
Evidence-based investing encourages a long-term perspective. Instead of buying and selling assets in response to short-term market fluctuations, EBI focuses on holding a diversified portfolio of investments for the long term. This approach aligns with the idea that time in the market is more critical than timing the market.
Diversification
Diversification is a critical component of evidence-based investing. Reducing risk involves spreading your investments across different asset classes, like stocks, bonds, and real estate.
By diversifying, investors can lower their exposure to the volatility of any single investment, increasing the likelihood of steady, long-term returns.
Cost Efficiency
EBI places a strong emphasis on minimizing investment costs. High fees and expenses can significantly erode investment returns over time. By choosing low-cost index funds and ETFs (Exchange-Traded Funds), investors can keep more of their money working for them.
Consistency
Evidence-based investing provides a consistent and disciplined approach to managing investments. It doesn’t chase hot trends or follow the crowd but instead relies on historical data and academic research to make informed decisions.
How to Implement Evidence-Based Investing
Implementing an evidence-based approach to investing is straightforward.
Start with a Clear Investment Plan
The first step is to create a clear and well-defined investment plan. This plan should outline your financial goals, risk tolerance, and time horizon. It should also specify your target asset allocation, including the percentage of your portfolio allocated to different asset classes, like stocks, bonds, and cash.
Diversify Your Portfolio
Investing in low-cost index funds or ETFs that track broad market indices will give you a portfolio with exposure to a wide range of stocks and bonds, effectively spreading your risk across different sectors and industries.
Minimize Investment Costs
High investment costs can eat into your returns over time. When selecting investments, look for low-cost options that offer competitive expense ratios (management fees). Vanguard, Fidelity, Schwab, and iShares are known for their low-cost index funds and ETFs.
Stay the Course
One of investors’ most significant challenges is resisting the urge to react to short-term market fluctuations. Evidence-based investing encourages you to stay the course and maintain your long-term perspective. Avoid making impulsive decisions based on fear or greed, and stick to your investment plan.
Regularly Rebalance Your Portfolio
Over time, your portfolio’s asset allocation may drift from your target due to market movements. To maintain your desired level of diversification, rebalance your portfolio periodically. Rebalancing involves selling assets that have outperformed and buying assets that have underperformed to bring your portfolio back in line with your target allocation.
Consult a Financial Advisor
If you’re new to evidence-based investing or feel overwhelmed by the complexities of managing your portfolio, consider consulting a financial advisor. A qualified advisor can help create a tailored investment plan and provide guidance on implementing an evidence-based approach.
Examples of Evidence-Based Strategies
Evidence-based investing encompasses a range of strategies that have proven effective over time. Here are a few examples:
Passive Index Investing
Passive index investing involves buying and holding low-cost index funds or ETFs that track specific market indices, like the S&P 500. This strategy aims to capture the overall market’s returns and benefits from diversification.
Factor Investing
Factor investing involves targeting specific factors or characteristics that have historically driven higher returns. Common factors include value (investing in undervalued stocks), size (investing in smaller companies), and momentum (investing in stocks with strong recent performance).
Asset Allocation
Asset allocation divides your portfolio among asset classes, like stocks, bonds, and cash. Evidence-based asset allocation strategies use historical data and statistical analysis to determine the optimal mix of assets based on your goals and risk tolerance.
Final Thoughts
Evidence-based investing offers a rational and disciplined approach to managing your finances and building wealth over the long term. By relying on empirical evidence, minimizing emotional bias, and following a diversified, low-cost strategy, you may increase your chances of achieving your financial goals.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy ensures success or protects against loss.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
Asset allocation does not ensure a profit or protect against a loss.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF’s net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.