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Why smart investors use evidence-based techniques

As anyone who has experience of navigating the financial services industry will know, plenty of service providers offer bold and sometimes unsubstantiated claims regarding their knowledge of the market. Indeed, it is not unusual for fund managers to tell prospective clients that they possess unrivalled knowledge that could help them pick the best stocks and, ultimately, ‘beat’ the market.

Such promises simply do not stand up to scrutiny, however. It may seem tempting to put one’s faith in the knowledge of experienced fund managers, particularly for rookie investors, but attempts to play the stock market in this way are not sustainable in the long run.

Investors looking to minimise risks whilst making decent returns should look instead towards evidence-based investing. Built on the principle that investments should be made using evidence drawn from stock market figures, this form of so-called ‘passive’ investment management has been shown to deliver more predictable returns in the long term, as well as incur cheaper fees.

What is the difference between passive and active investment management?

Active investing

This form of investment involves the help of fund managers who point investors towards which stocks to buy and at what kind of prices. Indeed, the logic behind this strategy is that the apparent expertise of the fund manager will help the investor to beat the market.

There is more than one way to go about active investing. Whilst one investor could choose to buy stocks only in major companies or in one specific sector, another may choose to invest in small companies or spread their investments across sectors.

Active investing tends to be the preferred choice of investors who like to add a little spice to their portfolios. It may suit those who are excited by a kind of ‘boom or bust’ approach to financial management. For most investors who appreciate long-term and reliable returns, it is not usually a viable solution.

Passive investing

Passive investing can broadly be described as a strategy that involves buying and holding on to stocks using historical data points that offer insight into their long-term profitability. Unlike active investing, this technique provides more predictable returns and allows investors to engage in minimal trading in the market.

One of the most popular forms of passive investing is index investing. This requires investors to try to replicate a specific market index’s performance.

Generally speaking, passive investing is less complex and less expensive than handling an actively managed portfolio.

The truth about the stock market

The stock market is difficult to beat in any consistent way and can be compared to betting on live sports. Whilst odds can be placed on certain stocks, it always involves risks and even the most knowledgeable experts cannot offer rock-solid advice.

In fact, the evidence overwhelmingly shows that successfully playing the stock market in any consistent way is very, very difficult and ultimately boils down to good fortune. What’s more, the few fund managers who manage to pull off successes year on year tend to charge very high fees for their apparent skills.

Why are markets so difficult to navigate?

The stock market is difficult to beat for a variety of reasons. Firstly, it is important to remember that security prices are set using the wisdom of millions of sellers and buyers. Thanks to the digital revolution speeding up the flow of information from economic figures and earnings reports, obtaining an edge over competitors is notoriously tricky. Remember that active investment is all about competition. If you profit from buying a stock that has been mispriced, someone on the other side of the deal has to lose out. The likelihood that you will win consistently is very, very low.

It is also important to remember that taking a chance on the market is an expensive game. Researching individual stocks can take a great deal of time and effort, not to mention the cost of trading and the salaries you have to pay out to fund managers. To make a profit, you must beat the market by a substantial margin a number of times over.

Finally, there is the fact that the stock market is sensitive to the changing news cycle. Something could happen on the world stage to affect stock markets in a way you may never have predicted.

So why is evidence-based investing the way to go?

As a largely passive investment strategy, evidence-based investing is underpinned by empirical research practices and the long-term study of market mechanisms. For example, it involves looking at the history of certain sectors or stocks and whether an investor is likely to expect high returns at a certain point in time. Unlike active investment, it is not based on instinct or risky guesses, making it a sensible option for investors hoping to make the most of their trade deals.

Studies overwhelmingly show that an evidence-based approach is the most lucrative

Studies on the best ways to invest consistently show that an evidence-based approach is best for investors looking to gain the highest returns. The S & P Dow Jones Indices, for example, publishes regular reports [link: https://us.spindices.com/spiva/#/about] comparing the returns of different fund managers. A clear pattern has emerged showing that active management is less lucrative over long time periods.

What are the principle of evidence-based investing?

The main principles of evidence-based investing include:

1. Setting a risk factor

It is important to decide just how risky you want your portfolio to be. Some investors may decide to put a large amount of money in low-risk areas such as bonds and gilts, whilst others may decide to dedicate a large portion of their portfolio to higher-risk investments such as equites.

2. Diversification

It is important not to put all of your faith in one investment. Ensuring that you have a healthy mix of investments spread across various companies and sectors will help protect you from market volatility.

3. Fees

Costs are a necessary part of investing that can mount up over time. Remember that taking risks also involves spending more money as it involves the work of fund managers and brokers. In this way, evidence-based investment is a great way to reduce the fees you will need to pay to invest.

4. Long-term returns

Evidence-based investing is all about long-term thinking. It is important to remember that things will not always go your way, so keeping a calm and steady mindset is important during times of market upheaval. A good financial advisor will help you to rebalance your portfolio if necessary, ensuring that your investments are geared towards your long-term goals.

Why do Huggins Wealth Management use evidence-based investing?

This article should have offered some insight into why evidence-based investing is a sensible option for investors looking to optimise their returns. Indeed, we at Huggins Wealth Management are interested in doing best by our clients and believe that encouraging an evidence-based approach is a good way to fulfil this.

Paul Huggins, Independent Financial Advisor at Huggins Wealth Management, says: “The proof of the power of evidence-based investing is in the numbers. If any of my clients are confused as to the degree to which their investment strategies have been active or passive in the past, it is easy to back-test the data and show that evidence-based investing is the sensible way to go. Come in and let me show you!”

The information in this article does not constitute personalised advice. You should contact your financial adviser for personalised advice including the suitability of any particular product or service for you. The information in this article should not be construed as an offer, invitation or recommendation to invest or take any other action.