Evidence based investment refers to the practice of basing investment decisions on empirical research and academic insights instead of speculation or intuition. With the rise of behavioral finance and big data analysis in recent decades, vast amounts of market data has been gathered and studied by scholars. This has led to the discovery of many market anomalies and investor biases that can be exploited for profit. By leveraging academic factor models and following a rules-based, backtested approach, evidence based investors aim to generate stable long-term returns.
Market efficiency has limits
While the efficient market hypothesis states that assets are fairly priced based on all available information, academic research has shown this is not entirely true. Factors like value, momentum and quality have historically led to market outperformance, suggesting some degree of inefficiency exists. By focusing a portfolio on stocks exhibiting these characteristics, investors can aim to capture the premiums associated with these factors.
Human biases persistently distort prices
Behavioral finance shows that cognitive biases negatively impact most investors’ decision making. However, evidence based investors can remain disciplined and avoid these pitfalls. For example, by avoiding selling winners too early or holding losers too long, momentum strategies exploit other investors’ disposition effect bias for profit.
Combining factors improves results
While single factor models can add value on their own, combining complementary factors like value and momentum has been shown to provide better risk-adjusted returns. This is because factors behave differently depending on the market environment, and multi-factor models have more diversification.
Simple, rules-based execution is key
Since following short-term market sentiment is often unprofitable for investors, evidence based strategies focus on relative value opportunities over longer time horizons. By pre-determining stock selection rules and rebalancing the portfolio systematically, discretionary decisions and turnover costs are minimized.
In summary, evidence based investing relies on the wealth of market insights uncovered by academic research in recent decades to construct disciplined portfolios positioned to outperform over the long run. By accepting that public markets have inefficiencies and investors are not always rational, superior long-term returns can be achieved.