Paul Tarins, RICP®,WMCP®,CSRIC™
Evidence-Based Investing: What Is It?
Some avid investors will say that there’s an art and a science to investing. But when it comes to choosing an investment style that works for you and your specific needs, you’ll likely come across terms such as passive investments, active investments, emotional investing, and evidence-based investing without much knowledge of what they are or how they differ. While you decide which types of investments you’re interested in pursuing, we’ve provided some helpful information to help you learn more about evidence-based investing and how it differs from other types of investment styles.
Remember, your choice of investment strategy is also essential for retirement planning. We recommend speaking to a financial consultant for more information on this.
Actives Versus Passive Investing
To start, you’ll want to understand the difference between active and passive investments. It’s important to note that there are many different types of portfolio strategies that incorporate both active and passive investments. Experts may at times recommend a mixture of both in an effort to help investors create an appropriate portfolio for their specific needs and tolerance for risk.
As the name implies, active investing tends to be a more hands-on approach. With this type of investing, you or your money manager is looking at more short-term fluctuations in the prices of stocks and bonds to decide when the best time is to sell or buy. In many cases, active portfolios are looked after by an analyst or a team of analysts who use various factors to decide when and what to buy or sell.
Some of the advantages and disadvantages of active investing include:
There is a greater potential for earning high returns and lowering your losses with active investing. This investment style attempts to increase your returns when the market is performing well. Conversely, it tries to control your losses when the market performs poorly.
Due to the hands-on approach required for active investing, active managers charge a higher fee. This can be as much as 2% or more of the assets under management.
Active management allows for more flexibility with respect to the assets and sectors you invest in.
Actively managed funds tend to generate short-term capital gains, which are subject to the ordinary income tax rate. This can increase your tax burden.
You can use your losses to reduce your taxable income and cut tax bills.
At times, active management can be more volatile than the benchmark it tracks.
With active management, you can include a variety of assets such as stocks, commodities, and options in your portfolio.
If we think of active investing as being a hands-on approach, consider passive investing more hands off. Taking a longer-term look at the market than its counterpart, passive investing strategies typically involve less buying and selling and more buying and holding. With passive investing, a certain amount of discipline is often needed to resist the urge to buy and sell based on current market conditions or economic climates.
Some of the advantages and disadvantages of passive investing include:
You pay less in management fees and commissions that are otherwise charged in active investing.
Your stocks may be concentrated in the top 50 or top 100 companies, which reduces your flexibility.
You primarily generate long-term capital gains, which are taxed at a lower rate.
A passively managed fund or individual account is subject to market volatility, and it may absorb most of or the same percentage of losses as the overall benchmark it tracks.
Your returns will be limited and seldom beat the benchmark it tracks.
A passively managed fund is simpler to manage, you may choose to self-direct this type of investment strategy
Depending on your age and risk appetite, choosing both as a compliment to each can make sense when allocating retirement funds and planning for consistency in your distribution strategy during retirement.
What Is Evidence-Based Investing?
With this approach to investing, investors make decisions about buying and selling based on what they know to be factually true. Instead of basing decisions on current market trends or conditions, investors turn to research, education, and historical data to guide their decision-making process.
Evidence-Based Versus Emotional Investing
Emotional investing is, as it sounds, investing with your emotions. As you hear unsavory news about a company’s CEO, your first reaction could be to quickly sell your stock before it tanks. But what happens if say, one month later, news breaks that the company’s new CEO has plans to double the company in size by the end of next year. Suddenly, their stock could be on the rise once more. Making your investment decisions based on your emotional or behavioral reaction to news, political changes or shifting economic climates is considered emotional investing.
Unlike emotional investing, the decision to buy or sell with evidence-based investing is not made based on current shifts in climate or news. Instead, it remains steadfast through trends and climate changes because it is based on predetermined factors and considerations.
Building an Evidence-Based Portfolio
Evidence-based portfolios rely on historical data and common factors that have persisted across financial markets. You can begin by evaluating which assets influence your portfolio. These can be stocks, fixed income securities, cash-based assets, commodities, and more. You can evaluate their respective rate of returns, the amount of risk they pose, and the benefits you can get if you diversify.
Once you have identified the assets you want to include in your portfolio, do some research on the external factors that influence their performance. For example, negative interest rates can drive up share prices and dividend payments. On the other hand, periods of economic uncertainty can cause the stock market to perform poorly. Stock market crashes have also been historically associated with gold bull markets. The performance of these two assets is negatively correlated to each other.
Once you determine which factors influence the performance of different assets, you can find out why these factors influence asset performance. This allows you to leverage economic trends in the future and prepare an evidence-based portfolio.
Since you understand the underlying factors that drive financial markets, you can also use this information to augment the performance of your portfolio. This way, even if the market is performing poorly, you will know that it will recover eventually. In the meantime, you can invest in other assets that appreciate during this period.
We also recommend learning about behavioral finance. Try as you might, it can be hard to ignore your instincts. When you are losing money, it can easily trigger your flight-or-fight response. However, if you are aware of how behavioral instincts impact investors, you can stay on track and continue executing your investment strategy.
Wrapping It Up
Whether you choose to take a do-it-yourself approach to portfolio management or you select an investment advisor to help you along the way, you’ll want to consider which types of investing will work best for your portfolio and unique needs. Understanding the difference between popular investment terms including active, passive, behavioral, and evidence-based is the first step to making informed decisions about your investment strategies.
Paul Tarins is an investment adviser representative of and offers investment and advisory services through Portfolio Medics, a registered investment adviser. Nothing contained herein should be construed as a solicitation for investment advisory services. Sovereign Retirement Solutions and Portfolio Medics are not affiliated