The best way to define investment risk is the probability that your investments do not achieve the desired investment returns. What if there was a way of guaranteeing returns i.e. reducing the risk to zero, you would be interested, right? Unfortunately, you can never reduce the risk to zero, but you can dramatically reduce risk by employing an evidenced-based investment approach.
What is evidenced-based investing?
Evidence-based investing is a widely used term that can mean different things to different people. For the purposes of this blog, evidenced-based investing refers to the process of adopting a set of rules to guide the implementation of the investment strategies and tactics. The efficacy of these investment rules is typically supported by long-term empirical evidence and peer-reviewed academic studies. That is, there’s an overwhelming body of evidence that proves these rules work and, perhaps most importantly, why these rules work. It is important to understand what has driven the returns – not just take the returns on face-value. You only invest when an overwhelming body of evidence exists that demonstrates you will be successful.
You can use evidence-based strategies when investing in all asset classes including residential and commercial property, shares and bonds. Some asset (sub)classes however are not suited to an evidenced-based approach such as private equity, small-cap shares and to a lesser extent emerging markets.
What is an example of non-evidenced-based investing?
By comparison, non-evidenced-based investing tends to have an absence of methodology and decisions are based on gut-feeling, speculation, subjective assessments, emotion and/or market noise/trends.
Stock picking is a good example of an investment tactic that is not evidenced-based. Whilst there are several generally adopted stock picking strategies (such as value or growth), the problem lies in the implementation. That is, very few “stock pickers” can consistently produce returns that beat the market. And when someone does beat the market, the reason for doing so is usually attributed to genius or luck (or both) – neither of which are repeatable skills for 99.9% of the population.
The advantages of evidenced-based investing
There are several advantages of adopting an evidenced-based investment approach, including:
- Repeatable: rules can be implemented repeatably. Therefore, you don’t need to formulate a new idea or approach every time you want to invest some monies. Instead, the rule can be implemented without your intellectual input.
- Lower cost: you don’t need to pay for ideas from a genius or oracle when using an evidenced-based investment approach. Instead, virtually anyone can implement proven investment rules – it’s like following a recipe.
- You can back test the results: one of the most pleasing benefits of using an evidenced-based approach is that you can measure the outcomes if you had have invested in this way over the past 10, 20 and 30 years (referred to as back-testing). Whilst past performance doesn’t guarantee future performance, it does give you some comfort of the returns you should expect assuming the investment environment is similar to what it was in the past.
- Easier to understand: when using evidenced-based investment strategies, you don’t have to put your faith in the opinions of one person (or a group of people). Instead, you are putting your faith in a proven methodology, a set of data, a factual observation and the like. Most evidenced based strategies can be explained using simple language, logic and/or maths. This makes them very transparent and inherently trustworthy. This puts investors at ease.
- Prevent you from making mistakes: Many financial mistakes (including indecision) are made because of emotional, reactionary, noise-driven investing. Following a set of rules takes the emotion out of investing. It is the absence of rules – especially in times of high stress and hysteria – that cause people to make financial mistakes. It is times like these that you need rules the most.
Examples of evidenced-based investing methodologies
The two major growth asset classes are shares and property. Therefore, let me share how we employ an evidenced-based investment approach when investing in these two asset classes.
There is an overwhelming body of evidence that demonstrates that the vast majority of professional fund managers fail to produce higher returns than the index on a consistent basis:
- The most recent study indicates that only 37% of Australian active fund managers beat the ASX200 index in the 5 years ended December 2017. Whilst the odds are stacked against you, it is therefore possible to pick a top performing active fund manager.
- However, updated research released this month (March 2018) indicates that there were 183 active managed funds in the top quartile (for performance/returns) for the 2015 calendar year. However, only 14 out of 183 remained in the top quartile for the calendar 2017 year i.e. only approximately 7.7% continued to beat the market 3 years later (and 1.1% 5 years later). This demonstrates that active fund managers might be able to produce good returns in one year but rarely follow that up in subsequent years i.e. outperformance does not persist.
- The average active fee charged by managed funds rated in the Canstar’s 2018 Star Ratings was 1.01% p.a. Passively managed index funds charge a fee in the range of 0.04% and 0.40% p.a. (average is around 0.20-0.30% p.a.).
Therefore, for an actively managed approach to work you, the evidence demonstrates that you have to be able to:
- Pick which fund manager will beat the market over the next 12 months;
- Divest of those managers in 12 months’ time and pick the next winners; and
- Do this with 100% accuracy, consistently each year so that the higher returns more than offset the higher (which are 2-10 times higher) fees you must pay and also offset the transactional and taxation costs resulting from high turnover.
In summary, the evidence demonstrates that active management almost guarantees lower net returns (save for random good luck). Therefore, you are better off to employ a low-cost passive approach as explained in this blog.
Direct residential property
Investment-grade property is any property that has a historic growth rate of over 7% p.a. over the past 30 to 40 years. There are three characteristics that are common to investment-grade property and they are:
- More than 50% of its overall value is represented in land.
- It has scarcity in terms of both (1) architectural style and property type and (2) it’s located in an area where land supply is scare to non-existent.
- Its historic growth rate is above 7% p.a. over the past 30 years.
There are also several asset-specific rules that should also be applied such as the property must have a logical floor plan, it must not be located on a busy road, apartments must have a car park on title and so on.
As I have discussed in this blog, property is part art and part science. Therefore, when applying these three rules you must understand what has driven the historic performance and how the performance compares to the market (type and geographic) segment over the same period. Unlike with shares, the investment rules get you most of the way but can sometimes result in inaccurate conclusions. Therefore, it is important to engage a reputable buyers agent to ensure asset selection is never compromised.
Are you interested in employing an evidenced-based investment approach?
If an evidenced based approach appeals to you, then you might like to consider engaging our financial advisory services. We welcome the opportunity to have a complimentary discussion to explore how we may be able to work together.