This is part 4 of the ‘Gold Standard’ series. In part 1 I mentioned the Twitter conversation I read that talked about the key factors in providing ‘gold standard’ advice being an adviser who…
- Is a Chartered Financial Planner
- Is a Certified Financial Planner (CFP)
- Practices ‘Lifestyle Financial Planning’
- Uses an ‘evidence based’ approach to investment strategies
In this final part I will be exploring what is meant by evidence based’ investing, and what it means for the advice process.
‘Evidence Based’ Investing
When building a financial plan, a key output is the rate of growth that you need to achieve on your assets in order to fulfil all your goals and aspirations. If this growth isn’t achieved, all the hard work in building the financial plan is meaningless. The results of this can range from having to reduce your expenses (maybe take less holidays) through to being forced to return to work. As such, the investment approach becomes the ‘engine’ that moves you along your ‘financial roadmap’.
Achieving this growth rate is therefore absolutely key. However, there are countless views on what is the ‘best’ way to invest money. There is a huge amount of guidance available from industry ‘experts’ including the investment companies, the press and advertising. That would be great if the stockbrokers, traders, fund managers and financial journalists acted solely in everyone’s best interests. But they all have a conflict of interest in some way.
So, if there is huge conflict of interest, how do you build a robust and reliable investment strategy? Especially when the goals you have for yourself and your family hinge on the results. In my opinion, the best way is to look at the evidence. Since the 1950’s, there has been a huge amount of academic research done into what works (and what doesn’t work) when investing money and building investment portfolios. By looking at the evidence and testing the theories we can build an approach to investing that is more likely to fulfil the needs of the plan.
But what evidence should we pay attention to? In our opinion, the evidence has to be:
- Independent – it can not be conducted by someone who has a vested interest in the outcome.
- Robust – the data the evidence is based on needs to be be robust.
- Reviewed by Peers – the academic evidence must be reviewed by peers in the academic community (again, these should be independent).
- Easily reproduced – other people must be able to reproduce the analysis (with enough knowledge) to show that the results aren’t ‘made up’ or ‘fudged’.
Once we have gathered the evidence, the task then becomes how to apply the evidence to deliver the highest chance of success.
What does this mean in practice? Well, lets look at one area in particular… Can ‘active’ management (i.e. stock picking and market timing) add value?
Lots of studies have been done on ‘actively managed’ investment approaches and whether they add value. The findings are that most actively managed funds have underperformed the relevant stock market as a whole over long time periods (in some academic findings the difference in performance has been as much as 1.8% per year less than the market). Barras, Scaillet and Wermers (Journal of Finance, 2010) did a study of 2,076 US funds between 1975 and 2006 and found that 99.4% of fund managers had no genuine stock picking ability. The 0.6% who appeared to have ability, were considered to be “statistically indistinguishable from zero”.
Graham and Harvey (National Bureau of Economic Research Paper #4890, 1994) analysed the recommendations from 237 investment newsletters from 1980 to 1992 and found that 75% of them produced negative returns.
The final study I will quote is one done by Fama and French (Journal of Finance: Vol LXV, No 5, 2010) where they looked at luck versus skill. The authors examined 3,156 actively managed funds between 1984 and 2006. They concluded that the net return (after fees) of the active management community were no better than what would be expected by random chance.
No one can predict the future, so why should they be able to predict when stock markets will rise (or fall), or when a particular company will do better (or worse) than the rest.
As a result, we do not use funds that are attempting to add value through stock picking and/or market timing (nor do we attempt this). Our clients goals and dreams are too important to gamble with. We’d rather base our investment strategies on approaches that have robust, independent evidence that shows they work.
If you would like to discuss how our approach to investing is different, please do get in contact. We’d be delighted to discuss it over a coffee.
An ‘evidence based’ approach to investing is all about creating an efficient and robust engine that drives the financial plan. When knitted together with an approach to financial planning that focuses on creating and keeping the life a client really wants, strong technical knowledge and the ability to create a financial plan that encompasses all your goals, the results are incredibly powerful. This is the kind of service that helps clients to make smart decisions with their money that helps them to live the life they want; both for themselves, and their loved ones. It also makes for a very fulfilling work life for me!
If you think this could be of interest to anyone you know, please feel free to pass on our details.