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 are no guarantees that you’ll earn the returns you’re aiming for, or even recover your stake. This leads us to why we so strongly favor evidence-based investing. Grounding your strategy 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 1950s, a “Who’s Who” body of scholars has been studying financial markets to answer key questions such as:

• What drives returns? Which return-yielding 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-yielding 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? As in any discipline from finance to medicine to quantum physics, it’s academia’s interest to discover the possibilities; it’s our interest to figure out what to do with the understanding. This is in part why it’s important to maintain the bifurcated roles of financial scholar and financial professional, to ensure each of us is doing what we do best.

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, ideal 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
• “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 rebut them with counterpoints.

Your 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 your ability to build and/or preserve long-term personal wealth according to your unique goals.