Evidence-Based Investing: What does it mean?

Evidence-based investing: What does it mean?

At Cambridge Partners, we don’t invest based on hunches or gut-feels. Our investment philosophy is based on academic evidence-based research spanning decades. In this article, we’ll highlight a few of the important financial theories that have influenced this.

The world of investing has not been plain sailing. Historically, investors would pick stocks based on what they liked or what they overheard was doing well and would then invest all their money into one or two assets.

Starting in the 1950s, the rise in modern financial theories was characterised by advancements in portfolio theory, quantitative modelling, risk management, and the efficient market hypothesis. This transformed the landscape of finance and investment practice. Investors became aware of more efficient ways to invest. Academics Harry Markowitz, William Sharpe, Eugene Fama and Kenneth French influenced the industry with their own theories and concepts, which remain relevant to today’s investors.

The academic giants behind the scientific evidence

Cambridge Partners uses an asset-class investment philosophy when constructing portfolios and selecting underlying fund managers or individual securities. The basic principles of asset-class investing are based on Markowitz’s Modern Portfolio Theory, the Fama-French Factor Model, Sharpe’s Capital Asset Pricing Model and Fama’s Efficient Market Hypothesis. These theories and concepts are the foundations on which Cambridge Partners’ investment portfolios are structured and how subsequent investment decisions are made.

Four key concepts of this scientific approach to investing are:

  1. Market prices reflect all available information: Prices adapt quickly to new information and fairly reflect the knowledge and expectations of all investors.  Therefore, extensive and expensive securities analysis is unlikely to provide sufficient benefit to consistently justify its cost.
  2. Diversification reduces unnecessary risks: Unsystematic or company-specific risks can be dramatically reduced through appropriate diversification, enabling the portfolio to principally be exposed to market or systematic risk.  Diversification is enhanced by holding most available securities within an asset class and including multiple asset classes (such as international shares and bonds) within the portfolio. 
  3. Investors are risk averse: The only acceptable risk is one that is adequately compensated for by potential portfolio returns.  Rational investors will not invest in higher-risk assets (eg, shares) if they have no long-term potential to earn more than investing in bonds or fixed interest.
  4. The design of the portfolio is paramount: The appropriate allocation of capital among asset classes (shares, bonds, fixed interest, etc) will have a greater influence on long-term portfolio returns than the selection of individual securities.  Investing for the long term (preferably longer than ten years) is central to investment success because it allows the long-term characteristics of asset classes to surface.

Asset class investing incorporates the scientific conclusions of Modern Portfolio Theory, the Efficient Market Hypothesis, and a significant body of academic research about the expected returns of investments.  This research identified the factors that explain long-term differences in share and bond returns that can be reasonably expected to persist into the future. The research demonstrates that the differences are economically sensible, persistent across time, pervasive across markets, robust to alternative specifications, and cost-effective to capture in well-diversified portfolios.

In 1990 Harry Markowitz and William Sharpe (with Merton Miller) received the Nobel Prize in Economic Sciences for developing models to assist with investment decision-making. While Eugene Fama received his 2013 Nobel Prize in Economic Sciences for his empirical analysis of asset prices (along with Lars Hansen and Robert Shiller).

8 August 2023

Disclaimer: This article is general information and does not consider your financial situation or goals and does not constitute personalised advice. There are no warranties, expressed or implied, regarding the accuracy or completeness of any information included as part of this article.

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