The investing documentary everyone’s talking about
Posted by Robin Powell on January 5, 2018
I’m a proud man today. After nine months of hard work, the full-length version of our new documentary, Investing: The Evidence is now online.
For those who don’t yet know how investing really works, watching this film might just be, in financial terms, the most valuable 45 minutes they ever spend. The response we’ve had to it so far has been overwhelmingly positive.
I’m going to explain exactly what’s in the film, and also what we mean by evidence-based investing, in a moment. But first I’d like to say a few thank yous. In particular I’d like to thank:
— RockWealth LLP in Cheltenham for commissioning the documentary;
— Ben, Sam, Will and all my hugely talented and professional colleagues at Regis Media for helping me make it;
— the academics, writers, advisers and fund managers who’ve contributed to the film; and especially
— Mark Hebner at Index Fund Advisors in California, who has probably done more than anyone to encourage me in my mission to change investing for the better.
For those who’ve been asking, we will be making branded versions of this film — and its standalone parts — for evidence-based advice firms outside the UK from April, and for UK-based advice firms from November 2018. Please note, however, that the number of licences on offer is strictly limited and they will be issued on a first-come-first-served basis.
We are also about to start work on a new, shorter documentary about evidence-based investing, and we will be making different versions of it for different countries. This film, too, will be rebranded for selected firms, but again, licences will be strictly limited per territory. Firms that are interested in having their own versions of either of these series, or indeed in collaborating with us on another series, should contact my colleague Sam Willet, at firstname.lastname@example.org.
What do we mean by evidence?
What exactly does evidence-based investing mean? After all, most investment professionals would claim to base their philosophy on some form of evidence.
In fact it’s remarkably easy to come up with an idea and then to claim it’s backed by rigorous evidence when, in fact, it’s nothing of the sort. In 2015, for example, a journalist named John Bohannon and two German TV producers set out to demonstrate how easy it is to turn bad science into the big headlines behind diet fads. Their challenge was to persuade as many media outlets as possible to publicise the results of “research” which “proved” that eating chocolate every day helps you lose weight.
So they spent a few thousand euros recruiting research subjects and a doctor to run the study. They intentionally used a tiny data set of 15 participants and just three weeks of data. Over a beer-fuelled weekend with a statistician friend, they sufficiently tortured the data to extract a technically accurate, if essentially meaningless, conclusion that chocolate consumption had indeed contributed to weight loss.
They submitted their paper to 20 different journals, and a few fake ones too, and within 24 hours the story was accepted for publication by dozens of publications around the globe. The study even made television news in the US and Australia.
Financial newsdesks are bombarded with “research” all the time, and very often it’s about as scientific as that study on chocolate and weight loss. Almost invariably it has been produced or commissioned by a company with a commercial conflict of interest.
But the problem with bogus evidence in the investment industry runs far deeper. That’s because the research that fund managers use to base their decisions on which stocks to buy and sell is, to a large extent, itself conflicted. Companies struggling for attention have been known to pay for the production of what looks like research by their broker. Those brokers often take payment for their work in warrants, or the right to buy the stock they have promoted at a future date at a substantial discount.
For fund managers, like journalists, it can be very hard to distinguish between research that is properly independent and research that isn’t. It’s often only at the end of a report that the truth is revealed, with a disclaimer along the lines of, “This material is not investment research”.
So then, what sort of evidence can investors rely on? In short, it’s academic evidence — but no, not all academic evidence. Generally speaking, reliable evidence has four main characteristics.
New studies are being published all the time which appear to support a particular investment strategy or course of action. But all too often these reports are produced, or else commissioned and paid for, by companies with a commercial interest in publicising the outcome. Most academics, by contrast, are independent. They don’t have an agenda or a point to prove; instead they leave it to financial practitioners to act on their findings or not.
It’s based on robust data analysis
We all know the old adage about lies, damned lies and statistics. It’s true, abuse of data can be very misleading. Often findings are based on too short a time period or a sample that’s too small. Sometimes the fund industry ignores survivorship bias; in other words, it overlooks those funds which performed so poorly that they no longer exist. Other times it compares returns to the wrong benchmark, or it quotes performance figures before the full impact of fees and charges. Sometimes it simply gets its maths wrong.
It’s been peer-reviewed
To test whether their findings are reliable, academics publish their research in credible academic journals. This gives other academics the chance to agree or disagree on whether the results are sound. Again, caution is required — there are journals that are less credible than others — but evidence that has been properly peer-reviewed should carry far more weight with investors than evidence that hasn’t.
The results have been reproduced
The fourth and final characteristic of findings you can depend on is that they’ve been tested across multiple environments and timeframes. There is some disagreement on the extent to which academic finance is properly scientific. Asset prices, for example, never move in exactly the same way as they have done in the past. However there does need to be a strong element of repeatability to demonstrate that the findings of a particular study weren’t just down to random luck or else reached through “data mining”.
The lesson, then, is to be very cautious about anyone claiming that a particular investment strategy is evidence-based. Even it fails just one of these four important tests, it’s probably worth ignoring.
One documentary, six separate parts
For those who don’t want to watch the full 45-minute version of Investing: The Evidence in one sitting, we’ve broken it down into six separate parts.
Here is a brief synopsis:
1. Active investing
Active investors try to beat the market though a combination of stock selection and market timing. You could, if you wanted, invest all your money yourself, in individual stocks, but the transactions costs incurred would be considerable, and would also be very time-consuming to monitor your portfolio. The vast majority of investors give their money to professional stockpickers who actively manage it for them.
Although it sounds great in principle, active investing is fraught with problems. First and foremost, it’s extremely difficult to beat the market over the long term, especially when costs are factored in; according to research* by the Pensions Institute in London, only around 1% of actively managed funds succeed in doing so, and spotting those very few winners in advance is all but impossible.
*New evidence on mutual fund performance: a comparison of alternative bootstrap methods by David Blake, Tristan Caulfield, Christos Ioannidis and Ian Tonks (2017)
2. Passive investing
Instead of trying to beat the market, passive investors simply aim to capture market returns by using funds that track an index. The two main advantages of using index funds are that, as long as you stay invested, you are guaranteed to achieve, near enough, the market return, and also that they’re very much cheaper to invest in than actively managed funds.
One of the biggest advocates of passive investing is, ironically, the most famous active investor of all, Warren Buffett. In his 2017 letter to Berkshire Hathaway shareholders, Buffett said this: “Both large and small investors should stick with low-cost index funds.”
3. Factor investing
Neither active nor passive, factor investing effectively combines the two. Sometimes referred to as smart, strategic or alternative beta, factor investing is based on the multi-factor model developed by two American academics, Eugene Fama and Kenneth French.
Fama and French have identified a number of different risk factors which, over time, are expected to produce higher returns than the market. Small companies, for example, perform better over time than large ones, while so-called value stocks tend to outperform growth stocks.
Factor investing is not a panacea; it does, for example, entail greater risk than passive investing, and it comes at a slightly higher cost.
There’s no escaping the fact that all investing involve a degree of risk. Risk and return are directly related to each other. The returns you receive are a reward for the risk you take. That doesn’t mean that taking risk guarantees a positive return, but you can’t expect your money to grow unless you’re prepared to accept the possibility that your portfolio could significantly fall in value, at least in the short term.
How much risk you take is a very personal matter; a portfolio that seems cautious to one investor can be highly risky to another. No one should take on more risk than they need to take, can afford to take or are comfortable taking, and whatever your own capacity for risk, you should always ensure your portfolio is well diversified.
Unfortunately, human beings are not cut out to be good investors. Evolution has taught us to focus on what we perceive as immediate threats. So, for example, when stock markets tumble, our brain’s amygdala floods our bloodstream with corticosterone, fear kicks in and we’re overwhelmed by the urge to sell. But successful investing demands that we try to control our emotions, that we look to the longer term and keep our discipline.
Another problem is that investors are prone to a range of behavioural biases. For example, we’re often overconfident; we deliberately look for information that confirms our particular view, and discard any that conflicts with it; and we pay far more attention than we should to recent events. To succeed at investing, we need to be aware of these biases and make a conscious effort not to let them divert our attention from what we should be doing.
Although it’s not essential to have a financial adviser, you are far more likely to achieve your goals if you do.
The important thing to remember is that investment advice is only part of what a financial adviser should be providing. His or her first priority is to work out what’s important to you and what you want to achieve, and, on the basis of that, to produce a financial plan. Then, and only then, is the adviser in a position to build a portfolio that’s appropriate to your personal capacity for risk.
In other words, it’s the plan itself, and sticking to it in the years to come, that should be the focus, not the particular funds in your portfolio. You should therefore look specifically, not for a financial adviser, but for a financial planner — someone who really takes the trouble to get to know you, who can act as your personal financial coach and, ultimately, help you to stay the course.
We would to thank the following for contributing to this documentary: Michael Batnick, David Blake, Jason Butler, David Chambers, Keith Cuthbertson, Tim Edwards, Charley Ellis, Ben Johnson, Lars Kroijer, Mark Hebner, David Pitt-Watson, Tim Richards and Larry Swedroe.