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Evidence-Based Investing

I thought I would take a minute to explain what exactly is evidence-based investing, as it is a popular term now.  I have neglected talking about it because it is how I manage money and approach financial planning.  Please accept my apologies as this is one of those times where I incorrectly assumed that if I know what evidence-based investing is I figured everyone else did.  Several people have asked me recently to explain it and my philosophy, so I thought I would break this topic down a bit more.

I’m going to steal a bit here from Josh Brown of Ritholtz Wealth Management and Robin Powell of the Evidence-Based Investor as they have done a great job of explaining what exactly is evidence-based investing and why it is important for your investment success.

For years the approach has been you go to the local office of some big brokerage firm.  The parking lots are full of new imports.  Offices have wood everywhere and walls are covered with images of bulls and bears.  Everyone is wearing a dark suit, white shirt and power tie.  The old guy you are meeting with belongs to at least one local country club, has been doing this for decades, and his investment approach is simply – “Trust me as I have been doing this for years.”

Evidence-based investing completely topples this approach as it is based on empirical evidence and statistical modeling.  Advisors make recommendations focusing on probabilities and rely on data with the recognition that getting from point A to point B with financial advising is never a straight line.  Portfolios are designed to help clients get to their end goals.  Part of the portfolio design is to make sure if something like the Great Recession happens again the client’s portfolio and goals are not devastated.

Here is where evidence-based investing can get a bit overwhelming.  There is no one “Portfolio to Rule Them All.”  Evidence-based advisors do not all have the same approach, but this does not mean one is right and the other is wrong.  While their approaches may differ, they are all based on evidence and data.

As Josh Brown mentioned in a recent interview, designing portfolios will never simply be input A plus input B resulting in C.  This would work if the market was mechanical.  Unfortunately, it is a biological market and will always be.  The majority of trades in every market are run by computers created by men.  Because of this there will never be one true law that controls the market, unless Skynet comes into existence and then only John Connor can save us.

I focus on three areas the evidence shows have the biggest effect on a portfolio.  They are asset allocation, keeping costs low, and controlling for taxes.  My portfolios include all the major asset classes, like large and small US companies, corporate bonds, international, and more.  Holdings are a mix of exchange-traded funds (ETFs) and low cost mutual funds.  And again, for taxable accounts I bring in an outside specialist who does the best tax-management I have ever seen and at a reasonable cost.

Allocations between these various asset classes vary based on how conservative or aggressive the portfolio is.  The primary goal is to design efficient portfolios where we improve the annualized return number while keeping risk as low as possible.  All portfolios are designed to personally reflect the individual client’s goals.

What is interesting with the shift to evidence-based investing is this is across generations.  Much of the demand for an evidence-based approach is rooted in how much information is available to us now.  While investors a few years back had a hard time getting access to the data advisors were using as the basis for their decisions, a client can now pull out a cell phone during a meeting to confirm an advisor isn’t just making crap up.

Studies show 35% of client’s do not fully trust their advisors are working in their best interests.  This is another reason I firmly believe the shift toward evidence-based investing will only get stronger.  Clients continue to improve their financial literacy (which I try to do through my emails) and demand more of their advisors.  But, hey, I am sure those advisors whose practices are based on the “trust me, I know what I’m doing” philosophy have nothing to worry about when their clients pull cell phones out during meetings.

About Dan Johnson, CFP

I am the President and CCO of Forward Thinking Wealth Management, LLC, which is the flat-fee financial planning firm located in Akron, OH, and set up to work virtually with clients across the country. I charge clients a flat fee of $4,800 regardless of asset size. My firm is a solution to what I feel is a broken system where clients pay advisors based on something out of their control - the performance of the market.
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