Following the evidence has become an increasingly important idea in investing in recent years. If we want to make informed decisions, it makes sense to understand what the evidence tells us. Unfortunately, following the evidence will not lead us to a definitive, correct answer – financial markets are far too messy and capricious for that. What evidence we choose to use and how we apply it is highly subjective and involves a host of trade-offs, which can lead reasonable people to disagree.  

Of course, not all evidence is created equal, some is robust and compelling – fees matter a lot to long-term returns and trying to time markets is a bad idea – but much of it is imperfect. A robust piece of evidence may directly contradict another equally strong argument. Investment decision making is about understanding what we are trying to achieve, assessing the available evidence and drawing a necessarily uncertain conclusion. 

To give a sense of how difficult it is to just ‘follow the evidence’, I wanted to give some examples of how the inescapable complexity of financial markets means that investors are perennially forced to make a whole host of subjective calls:

Static asset allocation versus valuation sensitivity: There is plenty of evidence that holding a static 60/40 portfolio allocation is an approach that is hard to beat over time. This idea, however, is probably outweighed by the evidence that valuations are a crucial driver of long-term return and risk. If we are following the evidence, what should we do? If we decide on fixed allocations, we ignore the evidence on valuations, if we make allocation adjustments over time based on changing valuations we ignore the evidence on the cost of taking active views. It is possible to argue either side and cite strong evidence – and this means we need to take a view.

Market cap equity versus equal weight equity: In 2013, a group of academics published a paper looking at alternatives to market cap weighting in equity indices and they found that doing ‘anything’ was better than a cap weighted approach – including portfolios ‘selected by monkeys’. At the time of publication, someone following the evidence could have quite justifiably preferred an equal weighted equity index fund compared to a traditional market cap weighted index fund. If they had done so, their relative performance would have been absolutely trounced in the years that followed. A lovely reward for taking heed of the evidence available. 

Not only would following the evidence have cost them, but the consensus now would be that market cap is superior to other approaches. So, with the benefit of hindsight, it would look like we were not guided by the evidence at all.

Global allocation and private markets: Many long-term investors reasonably take the view that the most prudent approach is to own something akin to the ‘global market portfolio’ and tailor it to their risk appetite. Given that private markets are a decent slice of the investable universe and more feasible access routes are emerging, does that mean these investors should now incorporate such strategies? Maybe. Or perhaps they should consider the evidence that expensive and complex products tend to come at a cost to clients over the long-run. There is an explicit choice to be made.

The small cap effect: On reading Fama and French’s seminal 1992 paper, an evidence-minded investor may have titled their equity portfolio towards smaller firms. The problem is that the evidence since publication has suggested that the size effect is only present in micro-caps, that it only works if you control for quality, or may not exist at all. Not only might seemingly compelling evidence be unreliable, it can also change based on better methods or new information. If you still believe in a small cap premium you are underweighting more recent evidence – which is fine – but it is an active choice that needs to be justified. 

Domestic bias: What does the evidence say about holding a domestic bias in our portfolios? It is a bad idea for most people, unless you happen to live in the US – then it looks like a great one. If I am in the US, should I rely more on the general rule about the cost and risk of a domestic bias, or the specific case of being a US investor? I have an opinion on this, but there will be plenty of people who disagree because of the evidence they choose to use. 

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There are many more examples of this I could give but the broad point is that very few things are simple or easy in the world of investing. The evidence about the investment decisions we should make is opaque, changeable and often conflicting. Even if we have all the relevant information to hand, it still requires us to have opinions and own them. We will never alight upon the right answer, just the one we think makes the most sense to us based on what we observe and who we are.

I am worried that by writing this I am giving a charter to make poor decisions and justify them by saying that because the evidence is incomplete anything goes. This is not the case. It is critical to filter out the nonsense and noise as best we can (and there is a lot of it). Even when we do, however, and are left with only high-quality information, we still have to discard or underweight some parts and emphasise others.

Judging the quality of the evidence available is not just a challenge due to the sheer scale of material available, but the fact that it changes (or at least can appear to).  Does twenty years of data that conflicts with the prior eighty years overwhelm it? When have markets sufficiently changed so that certain information is no longer valid? How valid is that 120-year data set today? Are we in a different regime now? Not only is it difficult to know what evidence should really matter, it is difficult to stick with something that is well-supported by the evidence available because – inevitably – there will be spells when it looks utterly incorrect.

Taking the time to assess the evidence and incorporate it into our decision making is crucial and the key underpinning of any investment process. It doesn’t, however, guarantee that it will lead to positive results – even if we do it well. We should, of course, still try, but we will need a little dose of good luck as well. All we can try to do is get the odds on our side.

I have focused here on the complexity and noisiness of financial market evidence. I have not started to touch upon the way in which we as individuals source, interpret and employ evidence – incentives, experience, temperament, environment and many other factors will all have a huge influence on how we engage with it. We are as muddled as the information we use.

Using evidence well is integral to good investment decision making but, unfortunately, there is not only one way to do it nor only one sensible answer to find. 

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

What does a difficult decision look like? One where there are lots of moving parts, a constant stream of new information, plenty of emotional stimulus, and nothing to stop us reacting to it all.

This is exactly the type of choice investors have to deal with – with one small addition. We have to make the decision over and over again.

Every interaction we have with financial markets creates a new decision point. We are constantly receiving new ‘information’ (I use this word loosely) and, implicitly, asking ourselves the question: “Do I need to change my portfolio?” *

Whenever we check our portfolio valuation, or even read a financial news article, it is shifting the way we think or feel about our investments. What we do about this will depend on how emotive or compelling whatever we are engaging with is.

To make matters worse, our choices are also unavoidably affected by entirely superfluous factors. If we are having a bad day, it will influence the type of investment decision we might make.

Unfortunately, we live in a world where we are increasingly bombarded by ‘investment stimulus’, and technological progress means that we can act on this immediately. Using one device and a few swipes or clicks, we can read a concerning article, check our declining portfolio valuation, and switch assets, all in the space of sixty seconds.

To have any chance of being a successful long-term investor, we need to make decisions that are consistent, slow, and infrequent. What does this mean?

• Consistent: Follow a process where we are clear about what our aim is and what information matters.
  
• Slow: Consider any new information carefully and never when in a hot, emotional state.
  
• Infrequent: Trade rarely. Doing nothing must be the strong default.

The problem investors face is twofold: 1) We are naturally disposed to be highly alert to new information, acutely sensitive to short-term risks, and responsive to what our emotions are telling us. 2) Technological and investment-industry developments mean that the environment is increasingly encouraging the exact behaviours that are likely to harm our chances of good long-term outcomes.

From an investment-industry perspective, the focus should never be on whether a piece of investment communication is a ‘good article’ or whether a rollout of platform technology represents ‘positive progress’. Rather, it should be asking: “Is what we are doing likely to help someone make good investment decisions over time?”

The job of industry participants should be to improve the odds of their clients meeting their objectives. To do this, understanding how what they do is likely to impact client behaviour is paramount, but often seems to be an afterthought.

Investment decisions are incredibly complex and difficult; it is very hard to achieve good long-term outcomes if we are forced to make them every day.

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* Very probably not.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Performance fees are one of the more puzzling aspects of the fund industry. They are often hailed as a way of best aligning the incentives of fund manager and client yet, in reality, frequently benefit the former at the expense of the latter. Often in an egregious manner. 

Let’s imagine a hypothetical conversation between a professional investor and a potential client:

Investor: “I have developed this fantastic new strategy that can deliver high, uncorrelated returns. The backtests are incredible. All I need is some capital to put to work”.

Client: “That sounds interesting, what would it cost?”

Investor: “I would want to keep 20% of any performance above cash.”

Client: “Okay. What about the cost of providing the capital?”

Investor: “That would be 1.5% a year.”

Client: “So you will pay me 1.5% to gain an economic interest in my large pool of assets?”

Investor: “Err…no. You will pay me 1.5% for it.”

Client: “Right. And what if the strategy goes wrong?”

Investor: “I am afraid that’s all on you.”

Client: “Sounds great, where do I sign?”

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If we developed our own high conviction investment strategy and sought to make it as lucrative as possible (for ourselves), we would want access to a large pot of assets (ideally somebody else’s) and to participate directly in its performance.* Getting paid a healthy annual retainer would be the cherry on the cake.

Is it unreasonable to suggest that fund managers levying performance fees should actually be paying clients for gaining access to sizeable asset pools? Perhaps, or maybe it is just unrealistic (the lights need to stay on). Clients are, however, providing the necessary capital, bearing the vast majority of downside risk and often paying out fees for volatility. Hardly a textbook example of incentive alignment.

While there has been some evolution in how performance fees are structured, the pace of positive change is slow and certain areas seem to be moving in the opposite direction.** We should not be surprised at this given how asymmetric the benefits and costs can be, and how they often they provide reward for luck or even simple market exposure, rather than skill. Never give up on a good thing!

Of course, it is a free market, asset managers can set their own charges and clients have the agency to decide if the terms are attractive. I would just encourage everyone to think carefully about how well-aligned their incentives really are.  

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* This would also be true for someone who had no investment skill.

** There are better and worse ways to structure performance fees. Too many fall into the latter group.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.