Investment Philosophy - Part 2

CONVENTIONAL VS EVIDENCE-BASED INVESTING


Defining the Market

Either you will try to “out-perform the market” or you will not.  This is not a challenge, it is the question we must all answer before forming an opinion on investing.  “The market” is defined by the benchmark which closest represents our investment strategy.  Benchmarks can be made up of a single index or a mixture of indexes.  Some popular indexes include the S&P 500, the Wilshire 5000, the Russell 2000, the Barclays U.S. Aggregate Bond Index, the Dow Jones Industrial Average, and the list goes on.  In order to measure your performance, each investor has a benchmark for comparison of risk and return.

These indexes are comprised of multiple investments and are meant to resemble the entire market basket they represent.  The S&P 500 index, for instance, is based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.  It is weighted by market value, and its performance is thought by many to be representative of the stock market as a whole.  So, if this index was your benchmark, could you beat it on a consistent basis after expenses?  Conventional, or active investing, strives to do so.  Evidence-based, or passive investing, on the other hand, believes you should expect optimal returns for the amount of risk taken year over year.

 

Consistent Basis and Expenses

There are two very important concepts to keep in mind when choosing between conventional and evidence-based investing, consistent basis and after expenses.  First, let’s talk about out-preforming on a consistent basis, in other words meeting or beating your benchmark year after year.  It is important to recognize only conventional investing is required to meet this test since evidence-based investing, by definition, will achieve market (benchmark) returns minus expense.  Conventional management is a zero-sum game.  For one to out-perform their benchmark, another has to under-perform, which would put the odds of out-performing at 50%...right?  Now, it is time to talk about the effects of investment expenses, such as transaction fees when trading securities, management fees, commissions, the opportunity cost of being in and out of the market, etc.  Conventional investing is more expensive than evidence-based management.  The conventional approach assumes that prices in the market are not accurate.  This leads to an attempt to predict the future price, which generally incurs higher costs and risk.  Let’s get back to beating the market on a consistent basis.  The odds of out-preforming were at 50%, but when expenses are thrown into the mix it gets much bleaker.  First, consider stock managers.  Over the 10-year period ending in 2013, only 19% of stock managers survived and out-performed their benchmarks.  Only 15% of bond managers survived and out-performed.  Said another way, 81% of stock managers and 85% of the bond managers who started the 10-year period under-performed their market index.  About half of the stock and bond managers did not even survive the 10-year period.

 

What Does Conventional Investing Look Like

Conventional investment management is the most common and dominant form of investing.  It is based on prediction and forecasting such as:  picking stocks which are expected to perform well in the future, moving in and out of industry sectors or asset classes, and attempting to time the market.   Many investment managers will call this active and/or tactical investing.  These methods are based on trying to predict the future direction of the economy, the stock market, or an individual stock.   As outlined above, the probability of out-performance is very low.  Furthermore, it cannot be determined what percentage of those who did out-perform the market can only be attributed to luck or chance.   So, we talked about professional managers, let’s talk about individual investors.  Some people approach investing from an emotional perspective.  They act impulsively…their reaction is typically sparked by fear or greed.  Some may get anxious about the stock market and decide to get out.  This may ease their fear, but soon after it will be replaced by the anxiety of missing out on a market recovery.  Investors who flee the market ultimately have to decide when to get back in.  The idea behind investing is to buy low and sell high.  Yet, following an emotional investment cycle sparked by impulsive decisions may bring an opposite effect: buying at high prices and selling at lower prices.

 

What Does Evidence-Based Investing Look Like

Evidence-based, sometimes called strategic or passive investing, is based in academia and historical data.  It does not allow emotion to influence our investing habits; it does not try to out-guess other investors; it does not rely on a crystal ball.  It takes the investor’s risk tolerance into account and believes you should expect optimal returns for the amount of risk taken, year over year.  As I am sure you have deduced by now, Zora Financial’s approach is evidence-based.  The next blog post will delve into evidence-based investing and bring clarity to our investment philosophy.