Our investment philosophy is based on Nobel Prize winning Academic Evidence. Evidence based investing is a synthesis of three academic principles: Efficient Market Hypothesis, Modern Portfolio Theory, and the Three-Factor Model. Together these concepts form a powerful, disciplined and diversified approach to investing. The result is globally diversified portfolios including over 12,000 stocks spread across more than forty countries, designed and engineered to capture market rates of return.
I. Efficient Market Hypothesis (EMH):
“In an efficient market, at any point in time, the actual price of a security will be a good estimate of its intrinsic value.”
-Eugene F. Fama
In an efficient market, prices are accurate because the market participants set them. So the question becomes do we have an “efficient market”, and what information goes into pricing a stock?
How a stock is priced?
In a very simplistic explanation a stocks price is simply set by the supply and demand in the market. The individual decisions of the market participants over the course of a trading day to either buy a stock (bid) or sell a stock (ask), determine the market price.
So the question becomes whether you believe the market has set the price accurately as Dr. Fama’s statement above reflects or do you believe the market has made a mistake in the pricing?
This simple question gets to the heart of the Efficient Market Hypothesis and directly impacts the way you invest your money!
So if the market participants set the price of a stock and therefore, the market as a whole, by their individual decisions then the question becomes what do the market participants base those individual decisions upon? The answer to that question is INFORMATION! And there are two types of information that the participants use to decide whether to buy or sell a stock.
So rational and irrational information determine how the price of an individual stock is set and therefore, how the market changes on a day-to-day basis and is set as a whole. We have rational information, which is “knowable”, but is typically not accurate with the market participants making two different decisions based on the same exact information. And we have irrational information, which is “unknowable” and impossible to predict because it’s based on each individual’s personal data. This is why Dr. Fama states that the market is random and unpredictable! However, because of the collective individual decisions of all the market participants buying (demand) and selling (supply) the market price is set and the market is an extremely efficient pricing mechanism!
So there is a choice to be made when investing your money. You either believe the market is efficient and the price is set correctly or you believe the market is inefficient and the price is set incorrectly.
If you believe the former, then you will no longer participate in stock picking where you try to pick the winner and avoid the loser. Instead you will build a globally diversified portfolio where you invest in asset class structured funds that invest in the entire market. Simple stated passive “index” style funds.
If you believe the latter, then you will continue to speculate and gamble with your money by trying to identify which stocks have been mispriced, utilizing active stock picking managers that will speculate and gamble for you, all while trying to take advantage of this perceived skill.
The evidence is in and it overwhelmingly supports what Dr. Fama has been saying since 1965!
II. Modern Portfolio Theory
The second basic component of Evidence Based Investing is Modern Portfolio Theory (MPT), which earned the Nobel Prize in Economics in 1990.
In 1990, three men, considered to be some of the greatest economists in the history of the world, came together to create the Modern Portfolio Theory (MPT). The collaborative minds of, William Sharpe, Merton Miller, and Harry Markowitz, produced this revolutionary financial ideology, which stated that it was possible to engineer a portfolio that could achieve a maximum expected return, for a particular amount of risk. This theory won the Nobel Prize in Economics in 1990, and is an extremely important tool in portfolio optimization, especially for risk-averse investors. Essentially, an investor who knows their risk tolerance can select a portfolio that has a standard deviation that is aligned with their level of risk. It is inadequate to use terms such as, aggressive, conservative, semi-aggressive, moderate, etc. in a uniform manner, when describing one’s investing approach or risk tolerance. This is because not everyone is the same in terms of what amount of risk is, “too much”, “too little”, or “just right”. For example, one person may feel that losing 10% on an investment is a moderate loss, while another person may think that the same 10% loss is catastrophic.
Essentially, MPT demonstrates that for the same amount of risk, diversification can increase returns. The task is to find assets with an academically proven risk premium and low correlations. The Efficient Frontier allows individuals to maximize expected returns for any level of volatility.
Source: Malkiel, Burton. “A Random Walk Down Wall Street”. 1973
Fama, Eugene; French, Kenneth. “The Cross-Section of Expected Stock Returns”. Journal of Finance, 1992
III. The Three Factor Model
The final component of the Evidence Based Investment philosophy is the Three Factor Model, which defines three independent dimensions of returns. It is possible to apply these factors to portfolios and measure the role each factor provides the overall portfolio as a whole.
Investing is uncertain. Until recently, much of investing involved guessing what really matters in returns. In 1991 this changed. Eugene F. Fama and Kenneth French, two leading economists, conducted an investigation into the sources of risk and return. Grounded in Efficient Market Hypothesis (EMH), their research revealed that a portfolio’s exposure to three simple but diverse risk factors determines the vast majority of investment results.
These three factors are referred to as the Three-Factor Model.
The Three Factors are:
- The Market Factor: the extra risk of stocks vs. fixed income
- The Size Effect: the extra risk of small-cap stocks over large-cap stocks
- The Value Effect: the extra risk of high book-to-market (BtM) over low BtM stocks
Evidence Based Investing utilizes the Three-Factor Model when engineering portfolios to determine the allocation between equities and fixed income, small and large equities, and value and growth equities in each model.
Source: Fama, Eugene. “Random Walks in Stock Market Prices”. Financial Analysts Journal, September/October 1965.