Evidence-Based Investment Insights: What Has Evidence-Based Investing Done for Me Lately?

March 25, 2024

In our last piece, “Factors That Figure in Your Evidence-Based Portfolio,” we introduced three key stock market factors (equity, value and small-cap) plus two more for bonds (term and credit). Combined, these five factors have long formed a backbone for many evidence-based portfolios.

Does this mean we have everything we need to know to build better and better portfolios? Hardly!

The Benefits Of Evolving Evidence

Continued research has helped us identify additional market factors at play, with additional potential premiums. Three of the more prominent among these include investment, profitability and momentum.

The investment factor. Companies that reinvest heavily to sustain profitability tend to deliver lower returns than those that distribute more net cash flow to shareholders.
The profitability factor. Companies with higher profitability have delivered premium returns over those with lower profitability.
The momentum factor. Stocks that have performed well or poorly in the recent past tend to continue to do the same for longer than random chance seems to explain.

Ongoing analysis has also helped us fine tune how to judiciously pair new and existing factors. For example, as described in a Dimensional Fund Advisors 2023 paper, “The Evolution of Small Cap Investing,” it appears small-cap investing may be improved by avoiding downward momentum when trading, and by filtering out small companies with relatively low profitability, heavy reinvestment costs and/or minimal cash flows.

Factoring For Alternatives

Beyond stock and bond market investments, another line of ongoing inquiry involves looking at investable assets from other markets.

Where might we identify investment premiums that can be cost-effectively mined, after taxes and trading costs? Where evidence suggests they exist, such as in alternative lending and reinsurance markets, we may be able to use these assets to further diversify existing investment portfolios. In “Reducing the Risk of Black Swans,” Larry Swedroe and Kevin Grogan explain:

“Like with factors, adding alternatives that represent unique sources of risk and return and that offer equity-like expected returns should allow us to lower a portfolio’s allocation to market beta (the riskiest factor), thus creating portfolios with even greater risk parity and even more diversified sources of risk. Because each of the alternatives we have discussed shows low correlations to other portfolio assets, we should end up with a more efficient portfolio, one with similar returns but less risk.”

Sustainable Investing

These days, many investors would also like their investments to contribute, or at least cause less harm to the greater good, while still delivering decent, if not stellar returns.

Ongoing research has helped here as well. An evidence-based outlook helps confirm when a sustainable investing theory appears to be robust in reality. It also suggests when a promising approach may not pencil out as hoped for, no matter how well-intended it may be.

The Big Picture On Evidence-Based Investing

We acknowledge that we have just thrown a lot of information at you in a compact space. Here are five best practices for incorporating new and existing investment factors into your investing:

Take your time. While a “new” factor may or may not have existed for some time, our ability to isolate them is more recent. The evidence-based community has had less time to assess their staying power. Time will tell how persistent they may be. Favor factors with longer, broader and more durable evidence.
Consider the costs. As touched on before, even if a factor exists in theory, that does not mean it can be implemented in real life. We must be able to capture an expected premium without generating costs beyond its worth.
Balance dueling factors. Sometimes, it can be difficult to build one factor into a portfolio without sacrificing another. Benefits and tradeoffs must be carefully considered at the fund level as well as for your individual goals.
Identify your priorities. How will you balance a desire to invest efficiently and sustainably? Equipped with solid evidence in an often emotionally charged arena, you will be better positioned to make the rational choices and informed decisions that best fit your heartfelt values and financial goals.
Do not forget to diversify. As we covered in earlier Evidence-Based Investment Insights, avoid concentrating too much of your wealth in any given factor, no matter its appeal. Ideal portfolios are still tempered by global diversification, based on the risk and return expectations each component has to offer.

How We Can Help

With so much at stake, no wonder opinions vary on when, how or even if various factors should play a role in your own portfolio management. This is where we believe an evidence-based advisor relationship is critical to your wealth and well-being.

Exciting new investments that erupt overnight based on scant evidence and concentrated events are unlikely reasons to alter a durable investment discipline. Instead, it is important to reflect on thoughtful questions such as:

Have the results been replicated across factors, over time and around the world?
Is there robust analysis, not only from industry insiders but from objective academics?
Has it survived extensive peer review, if not unscathed, at least free of mortal wounds?

All of this takes time. And yet, one need only glance at daily headlines to become awash in ideas from competing, often conflicting voices of authority. Being informed is helpful, drowning in information overload is not. Too much noise creates perpetual uncertainty, which can strip away all the emotional and performative advantages of a patient, disciplined approach.

We would be happy to speak with you individually about the latest evidence on factor investing, and how to best apply it to your own investment strategies.

Your Take-Home

By considering each new potential factor according to strict guidelines, our aim is to extract the diamonds of promising new evidence-based insights from the considerably larger piles of random data. We feel you are best served by heeding those who take a similar approach with their advice.

In the next installment of this series, we will turn to a factor we have mentioned but have yet to explore, even though it may be the most influential one of all: you and your financial behaviors.

This post was written and first distributed by Wendy J. Cook.

DISCLAIMERS

This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. This is not an offer to buy or sell a security.

Shore Point Advisors is an investment adviser located in Brielle, New Jersey. Shore Point Advisors is registered with the Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Shore Point Advisors only transacts business in states in which it is properly registered or is excluded or exempted from registration. Insurance products and services are offered through JCL Financial, LLC (“JCL”). Shore Point Advisors and JCL are affiliated entities.