What is evidence-based investing or EBI? Very generally, it is how science is done in the application of investing. More specifically, EBI is the field work of investing science where data are continuously collected, organized and analyzed by professionals who are academically trained in the science. As with any science, EBI demands a rigorous, objective and meticulous analysis of data.

The goal is to find long-term patterns that emerge from the data for application in long-term investing (not short-term market-timing tactics). These long-term patterns constitute the best evidence from which investment decisions can be made by an investor in consultation with their fee-only, fiduciary investment adviser.

EBI is an approach to investing that has come directly from academia and not a sales or brokerage office. As a result of its academic origin, EBI is currently practiced by very few investment advisers—usually limited to those highly trained advisers working exclusively with high net worth investors in a fee-only (not merely fee-based) fiduciary capacity.

Unlike brokerage, EBI is an objective, data-driven approach to investing. The data, and not a commission or fee, drive portfolio selection decisions within the framework of the individual investor's expected return and risk profile taking into account the attendant tax consequences of any investment selection.

EBI informs investors how to invest

So, what do the data show from the empirical studies with EBI? Said another way, according to EBI what matters in investing? The takeaways from EBI are discussed below. Of course all of these takeaways are of little assistance to an investor using an adviser who is not academically trained in EBI.

Asset class investing

Asset class investing is key. The challenge is determining which asset classes to include (and which to exclude) and how to weight the portfolio among the various asset classes (e.g., large cap, mid cap, small cap, international and others). The answer is not merely intuitive, nor is it simply based on an investor's age or years to retirement. The answer is much more scientific, using rigorous statistical analysis of both expected return and volatility risk.

The goal of asset class investing is diversification both within and among various asset classes in relation to a low cross-correlative relationship to mitigate the downside volatility risk of any one stock or asset class. Indeed, if designed correctly, it is possible for an investor to enhance his or her expected return while lowering the volatility risk thus approaching an optimally efficient frontier. Accordingly, if a portfolio is not found along the efficient frontier curve, then it is found somewhere beneath it. That is called an inefficient portfolio, inefficient in that an investor is taking on volatility risk for which he or she are not fully compensated.

So, which asset classes should we include and how do we weight the portfolio selections and when should we rebalance? Unfortunately, that is for the clients to know. The important point is, does your adviser know? Is his or her knowledge based upon evidence found in the literature followed by rigorous statistical optimizations?

Passive investing matters

The evidence is clear: Passive investing is superior to active management investingover the long term, especially considering style drift and all of the attendant fees, costs and expenses associated with actively managed mutual funds. How do we know this to be the case? From the ample evidence found in the research literature, some of the evidence goes back nearly 50 years from the pioneer work of Nobel Prize winner Dr. Harry Markowitz, to the highly regarded Brinson & Beebower studies of the last few decades. For further exploration of passive asset class investing, see our article titled "The Science of Investing" in the September 2009 issue of GLBM.

Size matters

It is true, size matters in investing. But what size matters? The evidence informs us that not all asset classes are equal, nor should all be used. Indeed, there is abundant evidence that plainly reveals that certain asset classes are critical to the long-term performance of your investment portfolio. By performance we mean not only expected return but also dampening of volatility risk among asset classes.

Ignoring this important aspect of investing can be hazardous to your retirement objectives. Yet, it is one of the most violated aspects of investing. So, again, what size matters? Which asset classes should be used or avoided?

Unfortunately, that is for the clients to know. The important point is, does your adviser know? Is his or her knowledge based upon evidence found in the literature?

Style or portfolio-tilt matters

Certain portfolio tilts should be avoided. Why? Again, based upon the evidence from academic research. As a corollary, other portfolio tilts should be included. Yes, again, due to evidence. The question is: What does the research tell us about portfolio tilts should we invest in growth or aggressive growth funds, neutral tilts, value funds and so on? Again, that is for the clients to know. The important point is, does your adviser know? Is his or her knowledge based upon evidence found in the literature?

Taxes matter

Appearing in the November 2006 GLBM, an article titled "Ask an Expert: Tax-Engineering Your Investments," explained in great detail certain strategies and approaches that fee-only investment advisers utilize in maximizing after-tax returns. It is important to remember that you only keep what is left after the government takes its portion. It is highly recommended that you work with an adviser who has substantial accounting and tax experience to optimize your after-tax return.

Investment fees and loads matter

Most actively managed investments pay commissions or a fee to your broker (aka adviser or financial/retirement planner). Commissions and fees are a real and significant drag on a portfolio's performance. Commissions are commonly listed as Class A, B or C. Take notice that a fund class designation has nothing to do with the quality of the fund; instead, it merely signifies how the load (i.e., commission) will be paid to the broker. These loads or commissions are paid regardless of how the actual investment performs. In addition to the various types of loads or commissions there are annual internal expense fees pouring out of these investments.

Of course, it could be even worse for the investor; he or she could be sold a variable or equity indexed annuity with a large surrender fee which can go on for several years (to cover the out-sized broker commissions which are always paid by the investor either directly or indirectly), plus mortality and expense fees, as well as separate account fees, and ultimately significant adverse tax consequences.

		Stephen L. Hicks, JD, MS, CPA and Roger L. Millbrook, JD, CPA/PFS, are Fee-Only Fiduciary Investment Advisers and principals of Siena Capital Management, LLC, serving high net worth individuals, professional practices, businesses and nonprofits.  Part of a larger Siena team, both advisers are accountants and lawyers holding other advanced degrees or designations in the area of financial services.

 

 

 

 

 

 

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