Warburton Capital’s Evidence-Based Investment Insights

The Essence of Evidence-Based Investing

Installment Eight

Last week a buddy visited us to review his long-term plan. He had been seduced by an advertisement for a mutual fund that was “ranked highest in its peer group” for performance. The fund has only been around for two years but, apparently, it’s run by a whiz kid in New York who has ‘a system’. We chatted for a while and I realized this topic was Newsletter Worthy!

Welcome to the next installment in Warburton Capital’s series on Evidence-Based Investment Insights: The Essence of Evidence-Based Investing.

In our last piece, “What Drives Market Returns?” we explored how markets deliver wealth to those who invest their financial capital in human enterprise. But, as with any risky venture, there is no guarantee that you’ll earn the returns you’re aiming for, or even recover your corpus. This leads us to why we so strongly favor Evidence-Based Investing. Grounding your decisions in rational methodology helps you best determine and stay on a course toward the financial goals you have in mind…especially when your emotional reactions threaten to take over the wheel.

So. what does evidence-based investing entail?

Market Return Factors: The Essence of Evidence-Based Investing – Since, at least, the 1950’s, a “Who’s Who” body of scholars has been studying financial markets to answer key questions such as:

What drives returns? Which return-enhancing factors appear to be persistent over time, around the world and across a range of market conditions?
How does it work? Once identified, can we explain why particular return-enhancing factors exist, or at least narrow it down to the most likely causes?

Financial Scholar vs. Financial Professional – Building on this level of academic inquiry, fund companies and other financial professionals are tasked with an equally important charge: Even If A Relatively Reliable Return Premium Exists In Theory, Can We Capture It In The Real World – After The Implementation And Trading Costs Involved? This is a huge question = What Do Premia Exist And Can They Be Captured?

As in any discipline from finance to medicine to quantum physics, it’s academia’s job to discover the possibilities; it’s our job, as Financial Professionals, to figure out what to do with the knowledge. This is in part why it’s important to maintain the bifurcated roles of financial scholar and financial professional, to ensure each of us are doing what we can do best in our field.

The Rigors of Academic Inquiry – In academia, rigorous research calls for considerably more than an arbitrary sampling or a few in-house spreadsheets. It typically demands:

A Disinterested Outlook – Rather than beginning with a point to prove and then figuring out how to prove it, genuine academic inquiry is conducted with no agenda other than to explore intriguing phenomena and report the results of the exploration.
Robust Data Analysis – The analysis should be free from weaknesses such as:
- Suspect data that is too short-term, too small of a sampling to be significant, or otherwise tainted. (The Two-Year Whiz Kid This Missive Opened With Is An Example)
- “Survivorship bias,” in which the returns from funds that were closed during the study (usually because of poor performance) are omitted from the results
- Comparing apples to oranges, such as using the wrong benchmark against which to assess a fund’s or strategy’s “success” or “failure”
- Insufficient use of advanced mathematics like multi-factor regression, which helps pinpoint the critical factors from among an otherwise confusing, noisy mix of possibilities
Repeatability and Reproducibility – Academic research requires results to be repeatable and reproducible by the author and others, across multiple, comparable environments. This strengthens the reliability of the results and helps ensure they weren’t just random luck.
Peer Review – Last but hardly least, scholars must publish their detailed results and methodology, typically within an appropriate academic journal, so similarly credentialed peers can review their work and agree that the results are sound or refute them with counterpoints.

Our Take-Home – As is the case in any healthy scholarly environment, those contributing to the lively inquiry about what drives market returns are rarely of one mind. Still, when backed by solid methodology and credible consensus, an Evidence-Based Approach to investing offers the best opportunity to advance and apply well-supported findings; eliminate weaker proposals; and, most of all, strengthen the ability to manage wealth in accordance with uniquely personal goals.

So, trusting you won’t be seduced, like our buddy, by the statistically insignificant (short period of time) out-performance demonstrated by the ‘whiz kid with a system’, we remain

Yours truly,

Warburton Capital Management