3 studies that support evidence-based investing

If you have ever tried to play the market, you will know the reality is that it is very hard to beat.

If it was easy, then what would be the risk? And if there were no risks, why would there be any return?

Evidence-based investing looks to empirical evidence and long-term market observations for investments, rather than basing decisions on gut feelings or trying to make predictions.

But what is the evidence that backs up this method?

Read on to discover three studies that support an evidence-based approach to investing.

1. SPIVA and the value of long-term investments

    One of the key tenets of evidence-based investing is to focus on long-term investments that you handle as little as possible.

    This approach comes with logistical benefits, such as minimising transaction costs and compounding returns, and there is also evidence to suggest that long-term holdings perform better than shorter-term active investments.

    Long-term investing is a strategy that aims to replicate the performance of a specific market index rather than trying to outperform it, and is characterised by minimal trading activity and a focus on longer time horizons. Conversely, short-term active investing is an approach that attempts to outperform the market and capitalise on immediate growth opportunities.

    S&P Dow Jones Indices publishes a biannual report, Standard & Poor’s Index Versus Active (SPIVA), that compares the returns of short-term and long-term investments, and looks at returns on different asset classes in various markets around the world.

    They measure the performance of actively managed funds against assigned benchmarks in the S&P 500.

    The graph below shows the percentage of actively managed large-cap US equity funds that underperform their assigned benchmarks each year.

    Source: S&P Dow Jones Indices

    The graph shows the underlying pattern is that the S&P 500 benchmarks tend to outperform actively managed funds.

    For example, in 2023, 60% of actively managed large-cap US equity funds underperformed their benchmarks.

    So, embracing a hands-off, long-term approach to investing often yields superior results, which is why it is a cornerstone of evidence-based strategies.

    2. Harry Markowitz and the benefits of diversification

      Portfolio diversification is an integral component of risk management and ensuring long-term stability, and it can also enhance your return potential.

      Because of its multiple benefits, it is sometimes said that diversification is the “only free lunch” in investing.

      Diversifying your portfolio might include spreading your investments across a range of asset classes, regions, or sectors. It is the investing equivalent of not putting all your eggs into one basket.

      The American economist Harry Markowitz first developed the ideas that underpin diversification in 1952. He pioneered the modern portfolio theory (MPT) with his paper in the Journal of Finance and was subsequently awarded a Nobel Prize for his work.

      A key component of the MPT theory is diversification.

      Diversification is predicated on the understanding that investments are generally either high risk and high return or low risk and low return. 

      Markowitz argued that investors could achieve their best results by choosing a balanced mix of the two based on an assessment of their individual risk tolerance.

      This approach means that poor performance in one area of your portfolio could be offset by strong performance in another. It also opens your investments to the growth potential of other markets and regions and ensures you avoid concentration risk.

      The chart below shows the performance of different asset classes over a decade.

      Source: JPMorgan

      As you can see, assets that performed well one year can perform badly in the next, and vice versa.

      For example, emerging market equities were the strongest performers in 2017 and then the weakest in 2018.

      Markets are volatile and with so many variables at play, the performance of a specific asset class, sector, or region is hard to forecast.

      So, diversifying your portfolio might not only help you mitigate losses, but could also help you capture the returns of wider markets.

      3. Daniel Kahneman and the importance of discipline

        There is considerable evidence that suggests that one of the biggest obstacles to reaching long-term investment goals is investor behaviour.

        When markets are volatile or global events leave the future looking uncertain, the tendency can be to cut your losses and withdraw from the market altogether. Conversely, when markets are strong and times are good, you may feel tempted to take bigger risks.

        These two “tactics” are two sides of the same coin, and the evidence shows that neither is a good long-term strategy for success.

        Daniel Kahneman, who recently passed away, was one of the best-known names in the field of behavioural economics, with his theory of loss aversion being his major contribution.

        Kahneman first proposed the theory in a 1979 paper, co-written with his long-time collaborator Amos Tversky.

        Loss aversion observes that people generally feel the pain of losing something more intensely than the pleasure of gaining something of equal value. You are more averse to losses than you are motivated by equivalent gains.

        Kahneman’s study revealed that a significant majority of people would take a risk to try and avoid a loss, but they are not willing to do the same for a gain.

        Sage Journals details multiple studies that have since shown that there are neural processes within the typical human brain that regulate our aversion to loss and to risk in general.

        When it comes to your investments, the human propensity for loss aversion could mean that you avoid risks and maintain a conservative portfolio. While this may be a safe strategy, it might mean your investments do not deliver the returns you need to achieve your goals.

        Loss aversion could also cause you to sell stocks during a market downturn to avoid further losses, which could mean you miss out on future gains if and when the market rebounds.

        During a market dip, any fall in the value of your investments could result in a paper loss, but it isn’t until you sell those stocks that you will experience an actual loss.

        Conversely, an evidence-based approach keeps your investments and gives your holdings a chance to recover, as, historically, markets have trended toward growth in the long term.

        Get in touch

        To find out more about what an evidence-based approach to investing could mean for you, get in touch.

        Email us at hello@vwmwealth.com or call us on 0141 229 4004.

        Please note

        This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

        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.

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