MOST investors select and buy stocks, bonds and mutual funds that they feel will over-perform and sell the ones that they feel will under-perform, basing their decisions on conventional wisdom. Apart from securities selection, conventional investing attempts to time the market to determine when to buy and when to sell with the goal of maximising returns.
Now, with advancement in data analysis and collection of historical data across decades of diverse market conditions, evidence-based investing strategies have emerged. It is a topic that is not well-known to many investors and of those who have heard of it, only a few understand it. Let us make an attempt to understand the concept of evidence-based investing and how an investor can use it.
What is evidence-based investing?
It is a disciplined approach to asset management that combines the data obtained from the past and present with honesty about the unknown future. While others use forecasts, relationships or emotions to guide their decisions, practitioners of evidence-based investing use facts, logic and reason. This concept is based on the evidence-based medicine method (first used in early 1990s) that has had such great success in the field of medicine. The ultimate objective of this style of investing is to maximise after-tax returns for investors while minimising risk and protecting portfolios from downturns in the market. This strategy decreases the maximum likely loss during bear markets.
Steps in evidence-based investing
The first step is to eliminate meaningless questions which means only good questions that can be verified should be asked. For instance, consider the following question: Did the market decline today out of concern over lower oil production? There would be no way to irrefutably verify either a positive or a negative answer to this question. There are countless unverifiable questions and statements which dominate investment news on a daily basis.
So, this brings us to the next step—the need to develop the right and meaningful questions. That means asking relevant questions that can be proved or disproved with reference to evidence. The questions must also have significance from the investor’s point of view. Once the right questions have been asked evidence can be applied to solve problems and integrate the individual investor’s values and goals.
The last step is evaluating the effectiveness and efficiency of the process. This involves analysing portfolio performance (after all costs) and revisiting the investor’s goals and values. Though experts agree on this three-step process, still evidence-based investing processes are ongoing.
A vast majority of investors take decisions based on fear and greed. They typically follow unscientific models based on untested and unproven hypotheses. If you understand and adhere to evidence-based investing concepts, you will be well ahead of the majority of the investing public, whether you are an individual or an institutional investor.
The writer is associate professor of finance and accounting, IIM Shillong