If you went to your doctor with a complaint, how would you expect them to make a diagnosis?
Would you expect them to base their assessment on years of scientific evidence and research? Or should they give you their opinion based on their personal approach and beliefs?
If you’d prefer them to use decades of research, then evidence-based investing is likely to appeal to you.
An investment approach based on decades of evidence
In simple terms, evidence-based investing is an approach based on research. It considers the long-term observation of markets and how they work.
Rather than guessing which markets or companies might do well in the future, it’s rooted in facts and observation.
- Active investing – where a fund manager will try and “beat” the stock market’s average return. These experts try and guess when to buy and sell certain shares, bonds, and other assets. Using data, they predict when prices will change and trade accordingly.
- Evidence-based investing – investors buy and hold a highly diversified portfolio of low-cost funds. Other than rebalancing when necessary, trades are infrequent to reduce costs.
The truth is, even for the best investors, markets are hard to beat in the long run. Picking the right investments can be tough. Buying and selling at the right time is difficult, expensive and often leads to losses.
In essence, evidence-based investing is about using a broad range of funds. As you’ll see shortly, it’s also about minimising costs by trading as little as possible.
A disciplined, low-cost strategy
Let’s say a fund manager has a strong feeling that an asset is underpriced, and profits from buying it. Here, there must be another person who has lost out on that trade. As an investor, you’re winning at somebody else’s expense. Outguessing the market becomes a zero-sum game.
Having a fund manager speculate on your behalf is akin to gambling. Research has found that these actively managed investments rarely outperform index funds (those that track the market).
CNBC report that, according to Morningstar, only 24% of all active funds beat the average of their rival index funds in the decade ended June 2020.
In contrast, evidence-based investing is a transparent process. And it’s backed by decades of research.
As author John Bogle says: “Don’t look for the needle in the haystack. Just buy the haystack!”
Another benefit of evidence-based investing is lower costs.
Index funds cost about five times less than active funds, say Morningstar. An investor with $10,000 in the average index fund paid about 0.13% annually to own that fund in 2019. An active fund holder paid 0.66%.
And then there are the trading costs. Here’s how increasing the number of trades a year (assuming a cost of £9.95 per trade) affects your returns. The table is based on a £5,000 initial investment. It assumes growth of 5% a year before charges.
Lower costs mean evidence-based investing can generate higher returns
Higher costs affect investment performance, and by more than you think.
Here’s an example. It assumes a £100,000 investment with no other fees and an annual 5% growth rate.
You can clearly see that even paying a charge of 0.5% compared to 0.1% significantly reduces returns. Higher charges would eat up around £19,000 of your investment over 20 years, and more than £45,000 over 30 years.
The conclusion is simple. If you reduce your investment charges by using an evidence-based approach, it can generate superior returns.
Research has shown that assets which offer higher expected returns share certain characteristics. These are called “dimensions”.
Evidence-based investing structures a broad and diversified portfolio that emphasise these dimensions. It means looking at information about expected returns from the market itself. It’s not about making guesses and predictions.
This approach means leveraging the collective knowledge of the market’s millions of buyers and sellers. It also trusts markets to do what they do best — drive information into prices.
Instead of spending time making guesses, we can focus on servicing your needs. And you benefit from the peace of mind of a transparent approach backed by decades of research.
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The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.