As the name would suggest, evidence-based investing uses evidence to fashion an investment strategy. The evidence shows that no-load, low-cost index funds allocated over a wide range of asset classes handily outperform actively managed funds, especially over the long term and after accounting for fees and taxes.
It’s not impossible to time the market or pick the next Apple or Facebook, but you should recognize the odds against doing so.
As legendary investor Warren Buffett stated: “Basically, any attempts to pick the times to buy or sell, I think are a mistake for 99% of the population. And I think that even attempts to pick individual securities are a mistake for people.”
By any other name…
Evidence-based investing is a fairly recent term for an idea that has been around for quite some time. In 1974, John C. Bogle formed Vanguard with the then-radical intent of providing no-load, low-cost mutual funds.
His investing philosophy, as summed up in his book The Little Book of Common Sense Investing, was simple: “Owning a diversified portfolio of stocks and holding it for the long term is a winner’s game.”
Bogle also said, “Trying to beat the stock market is theoretically a zero-sum game (for every winner, there must be a loser), and after the substantial costs of investing are deducted, it becomes a loser’s game.”
Warren Buffet paid homage to Bogle, stating: “If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle.”
Naysayers of evidence-based investing
Since the arrival of those early Vanguard funds, detractors have been predicting the imminent underperformance of index funds, but they have consistently outperformed actively managed funds.
Based on the evidence, other mutual fund companies, including big names such as Fidelity and Schwab, started offering similar funds to those offered by Vanguard. In the late 1990s, the introduction of exchange-traded funds (ETFs) provided another low-cost investing option.
There are several common objections to evidence-based investing:
You’re looking in the rearview mirror, not at what lies ahead. Index funds don’t take into account the latest news concerning the individual stocks in their indexes. If all those index fund owners decided to sell at the same time, pandemonium might ensue.
- Historical evidence on the performance of low-cost index funds lends credence to making them the core of your investment strategy.
Over the long term, simply buying index funds that track an index has trounced the returns of comparable activity-managed mutual funds. Need some evidence? Here are some facts about evidence-based investing over the past 20 years:
- 95.39% of all actively managed domestic stock funds underperformed their benchmark indexes
- 87.88% and 94.74% of actively managed international and emerging market fund categories, respectively, underperformed their benchmarks
- For bond funds, the data ranges (for a 15-year period) from 62% of actively managed government long funds underperforming to 100% of actively managed investment-grade short funds and emerging market debt funds underperforming.
Not surprisingly, studies suggest that the average retail investor also has a very low probability of outperforming an index fund by picking individual stocks. That doesn’t stop some investors.
As Burton Malkiel, author of the investing classic, A Random Walk Down Wall Street, wrote, “For many of us, trying to outguess the market is a game that is much too much fun to give up.”
Malkiel added, “Even if you were convinced you would not do any better than average, I’m sure that most of you with speculative temperaments would still want to keep on playing the game of selecting individual stocks with at least some portion of the money you invest.”
Recognizing the strong pull of chasing stock “winners,” some evidence-based financial advisors advise setting aside a small portion of assets (like 10%) as “mad money” that can be used to invest in individual stocks.
The peril of timing the market
Han Solo famously sensed when trouble was brewing and it was time to get out. Many individual investors believe they have the same sixth sense. The data suggests otherwise. Investors who try to time the market, supposing they know best when to buy low and sell high, often end up shooting themselves in the foot.
The best strategy is to either invest your funds immediately or choose the dollar-cost average. And once you’re invested, stay invested. Missing the ten best days in the market, stretching back to 1930, would have lowered your return from 17,715% to just 28%. Those best days often followed big market drops, which is when market timers often decide to sell.
Why it matters: according to evidence-based investors
The fairly recent field of behavioral finance teaches us that we cannot always trust our gut, or even logic, to make sound financial decisions. Sometimes, it pays to take our financial instincts out of the equation. Following the simple tenets of evidence-based investing can let us do just that.
Know more about evidence-based investing by talking to our financial advisors at Allied Integrated Wealth.