A Summary of the Principles and Benefits of Evidence-Based Investing
by Chris Brown, PhD, CFP® and Ron A. Rhoades, JD, CFP®
Investment portfolio design should be guided by sound academic research—not just findings from a single study, but through a process where discoveries are revealed, peer-reviewed, and verified across multiple datasets.
In this brief article we summarize the principles of “Evidence-Based Investing” (EBI). These principles go beyond simply using “factors” in investing. They include concepts such as diversification, strategic asset allocation, rebalancing, tax-efficient portfolio management, and techniques designed to counter behavioral biases that often lead investors astray.
The following readings are derived in large part from from Ron’s book, Mastering the Science and Art of Investing: Multi-Factor Strategies for Portfolios Both Prior to and During Retirement, currently used as a textbook in his Applied Investments course within the Department of Finance, AACSB-accredited Gordon Ford College of Business, at Western Kentucky University.
What Is Evidence-Based Investing?
Investing often seems complicated and unpredictable. Many believe success comes from instinct, luck, or outsmarting the market.
Evidence-based investing (EBI) offers a different approach – one grounded in research and disciplined decision-making. EBI champions a systematic method that relies on decades of historical data and academic research to guide investment decisions.
EBI is a structured framework for creating investment strategies and managing portfolios. It combines past and present data, scientific theories, and our understanding of markets to inform decisions. The core philosophy: investors should use an analytical approach -similar to methods used in science – rather than relying on hunches or predictions.
The Foundation: Modern Portfolio Theory
The cornerstone of EBI is Modern Portfolio Theory (MPT), a groundbreaking investment framework developed by Harry Markowitz over 70 years ago. MPT won Markowitz a Nobel Prize and revolutionized how we think about investing.(ii)
In simple terms, MPT shows that investors can build optimal portfolios by understanding the relationship between risk and return. Instead of trying to pick “winning” stocks, the goal is to create a portfolio that delivers the best possible returns for a specific level of risk.(iii)
In his influential 1952 paper, “Portfolio Selection,”(iv) Markowitz laid the foundation for this approach. He introduced several key concepts:
- Risk and Return Tradeoff: Higher expected returns typically come with higher risk, while lower-risk investments generally offer lower returns.
Note: Interestingly, research has found a “low-risk anomaly” where certain low-volatility stocks can produce higher risk-adjusted returns than highly volatile stocks.(v) This finding has led to the development of “low-volatility” investment strategies.
- Diversification: By spreading investments across various assets with different risk characteristics, investors can reduce overall portfolio risk without sacrificing expected return.
MPT tells us there are two types of risk: market-wide risk that affects all investments (systematic risk) and company-specific risk (idiosyncratic risk). While you cannot eliminate market risk, you can significantly reduce company-specific risk through diversification.(vi)
- Efficient Frontier: This concept represents portfolios that offer the maximum expected return for a given level of risk. Portfolios on the “Efficient Frontier” are considered optimal because they provide the best possible return for your risk tolerance.(vii)
The Power of Diversification
One of the most important principles in evidence-based investing is diversification – i.e., the idea that you should not put all your eggs in one basket.
Modern Portfolio Theory shows that by investing in a diverse collection of assets, you can reduce your portfolio’s overall risk.(viii) Different investments rarely move in perfect sync with each other. When some assets lose value, others may gain, reducing your portfolio’s overall volatility.
John Bogle, founder of Vanguard, emphasized in his book The Little Book of Common Sense Investing(ix) that diversification is the only way to ensure investors get their fair share of market returns. He noted that it is impossible to predict which individual stocks or sectors will outperform each year. However, he stated by investing in a diversified portfolio, you participate in the overall growth of the market over time.(x)
Key takeaways about diversification:
- Diversification is essential for reducing portfolio risk. By spreading investments across various asset classes and sectors, you reduce the impact if any one investment performs poorly.
- Some mutual funds and exchange-traded funds provide a simple, cost-effective way to diversify. These funds can provide you with exposure to hundreds or thousands of stocks.
- Focus on long-term goals rather than trying to time the market.(xi) With a diversified portfolio held for the long term, you maximize your chances of success.
Understanding Investment Factors
EBI extends traditional investment models by introducing the concept of “factors”—characteristics that can influence investment returns.
In simple terms, a factor is a trait or condition that can affect how an investment performs. As Cliff Asness, co-founder of AQR Capital Management, explains: “A ‘factor’ is the spread between the return on one set of securities, systematically and clearly defined, versus another.”(xiv)
Academic research has identified less than a dozen factors that fairly consistently explain differences in returns among securities over most long periods of time.(xv) Major factors worthy of consideration, in the authors’ view, include:
- Size: Smaller companies often yield higher returns than larger ones over long periods.
- Value: Stocks that are inexpensive relative to their fundamentals have historically outperformed more expensive ones.
- Profitability: Companies with high profits relative to their assets tend to outperform.
- Investment: The tendency for companies that invest less in capital expenditures to outperform companies that invest heavily in new projects or assets.
- Momentum: Investments that have performed well recently often continue to perform well in the near term, which is best captured by the timing of trades of securities that are planned to occur for other purposes.
A few other factors exist that possess academic support, but the foregoing factors, when combined, are likely to capture excess returns over the long term in a cost-effective manner.
In 1992 and 1993, Eugene Fama and Kenneth French published groundbreaking papers(xvi) introducing their three-factor model, which explains that stock returns are primarily driven by:
- Market risk: How much a stock moves relative to the overall market;
- Size: Small stocks versus large stocks;
- Value: Stocks with high book value relative to market price versus those with low book value relative to market price;
Later research expanded this to include additional factors like profitability(xvii) and investment patterns(xviii) and momentum.(xix) The current Fama-French six-factor model explains about 85% to 93% of a diversified portfolio’s return.(xx)
It is worth noting that hundreds of alleged factors have been introduced over the years, leading to what economist John Cochrane called a “zoo of factors.”(xxi) However, research indicates that only about a dozen or so well-established factors are sufficient to explain most investment returns, and some of these overlap each other.(xxii)
Portfolio Rebalancing: Maintaining Your Risk Level
Evidence-based investing acknowledges the challenge of predicting market movements. Instead of trying to time the market, EBI focuses on strategic asset allocation and regular rebalancing.
Over time, as different investments perform differently, your portfolio can drift away from your target allocation. For example, if stocks perform well, they may grow to represent a larger percentage of your portfolio than intended, increasing your risk exposure.
Rebalancing means periodically adjusting your portfolio back to its target allocation. This disciplined approach helps maintain your desired risk level.(xxiii)
A 2012 paper by Bouchey and colleagues(xxiv) explored “volatility harvesting”—the process of capturing additional returns through rebalancing. When you rebalance, you’re essentially selling investments that have performed well (selling high) and buying those that have underperformed (buying low). This process takes advantage of price fluctuations and can enhance portfolio performance over time.(xxv)
The Critical Impact of Fees and Costs
Investment costs play a crucial role in evidence-based investing. High fees can significantly reduce your long-term returns.
John Bogle, founder of Vanguard, was a strong advocate for keeping investment costs as low as possible. In his book Common Sense on Mutual Funds he stated that “costs are the single most important predictor of long-term investment returns.”(xxvi)
Research consistently shows that high-fee investments typically underperform their lower-cost alternatives after accounting for costs. A study by Cooper, Halling, and Yang found a strong negative relationship between mutual fund performance and mutual fund fees.(xxvii) This is why EBI emphasizes low-cost investments.
Overcoming Behavioral Biases
Evidence-based investing also incorporates insights from behavioral finance – understanding how emotions and cognitive biases affect investment decisions.
We humans are not always rational when it comes to money. We may panic and sell during market downturns (when we should potentially be buying) or chase performance by investing in whatever has recently done well (often buying high).(xxviii)
A well-crafted Investment Policy Statement (IPS) can help overcome these behavioral biases. An IPS is a written document that outlines your investment goals, risk tolerance, and strategy. It serves as a roadmap for making investment decisions and helps prevent emotional reactions to market events.(xxix)
By committing to follow your IPS, you create a disciplined framework that can help you avoid common investment mistakes and stay focused on your long-term goals.
Understanding Future Returns
When planning for retirement or other financial goals, we often need to project long-term average returns. EBI offers insights into the relationship between current valuation levels and expected future returns.
Historically, asset classes with higher valuations have generally experienced lower average returns over the long term (10-20 years).(xxx) This makes intuitive sense – if you’re paying more for future earnings, there is less room for additional growth.
However, valuations are not perfect predictors of future returns, especially within shorter periods of time. Asset classes with high valuations sometimes continue generating strong returns, while those with low valuations don’t always produce higher returns.(xxxi)
While EBI doesn’t support using valuation levels to time the market, considering current valuations can help create more accurate projections for your financial plan.
The Benefits of Evidence-Based Investing
Evidence-based investing offers several important benefits:
- Reduced Risk: EBI’s focus on diversification, low costs, and long-term investing helps reduce portfolio risk and minimize emotional decision-making.
- Enhanced Returns: By following EBI principles, you increase your chances of achieving your long-term financial goals.
- Improved Investor Experience: EBI promotes a rational, disciplined approach to investing, reducing the stress and anxiety often associated with market fluctuations.
- Greater Accessibility: EBI strategies are increasingly available through low-cost mutual funds, ETFs, and (for some investors) customized portfolios of individual securities.
Conclusion
Evidence-Based Investing combines empirical evidence, sound theory, and an understanding of market behavior. It moves away from speculation in favor of a disciplined, research-based approach to investment management.
By applying principles like Modern Portfolio Theory, diversification, factor investing, a disciplined approach to portfolio rebalancing, tax-efficient portfolio design and management, cost management, and behavioral discipline, EBI helps investors build resilient portfolios that can weather market volatility.
As the investment landscape continues to evolve, evidence-based investing remains a valuable framework for navigating the complexities of the financial world and achieving your long-term financial goals.
About the Authors
Ron A. Rhoades, JD, CFP®
Ron Rhoades is an Associate Professor of Finance at the Gordon Ford College of Business, Western Kentucky University. He also serves as a financial advisor at Scholar Financial, a practice within XY Investment Solutions LLC. With a background as both an attorney and a CERTIFIED FINANCIAL PLANNER™ professional, Ron is a nationally recognized authority on the fiduciary duties of financial advisors.
Chris Brown, Ph.D., CFP®
Chris Brown is a faculty member in the Department of Finance at the Gordon Ford College of Business, Western Kentucky University, and a financial advisor at Scholar Financial, a practice within XY Investment Solutions, LLC. He holds the CERTIFIED FINANCIAL PLANNER™ designation and a Ph.D. in Personal Financial Planning. His research and teaching focus is on behavioral finance, retirement planning, and evidence-based investment strategies.
Disclosure
This guide is for educational purposes only. It should not be construed as financial, legal, tax, or investment advice, nor as a recommendation to implement any specific strategy, product, or investment. Consult with a qualified financial professional before making investment decisions.
Refences
ii Harry Markowitz was awarded the Nobel Memorial Prize in Economic Sciences in 1990, along with Merton Miller and William Sharpe, for their work on the theory of financial economics. Nobel Prize. (1990). The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1990.
iii Markowitz, H. M. (1952). Portfolio selection. The Journal of Finance, 7(1), 77-91.
iv Id.
v Frazzini, A., & Pedersen, L. H. (2014). Betting against beta. Journal of Financial Economics, 111(1), 1-25. See also Ang, A., Hodrick, R. J., Xing, Y., & Zhang, X. (2006). The cross-section of volatility and expected returns. Journal of Finance, 61(1), 259-299. See also Blitz, D. C., & van Vliet, P. (2007). The volatility effect: Lower risk without lower return. Journal of Portfolio Management, 34(1), 102-113.
vi Markowitz, H. M. (1952). Portfolio selection. The Journal of Finance, 7(1), 77-91.
vii Id. In his paper, Markowitz defined the Efficient Frontier as the set of portfolios that offer the maximum expected return for a given level of risk [1]. He showed that by diversifying a portfolio, an investor can reduce risk while maintaining a desired level of return. The Efficient Frontier represents the optimal portfolios that provide the best possible return for a given level of risk.
viii Id. In Markowitz’s formulation, the standard deviation of returns is defined to be the measure of risk.
ix Bogle, J. C. (2017). The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. John Wiley & Sons.
x Id.
xi See, e.g., “The Futility of Market Timing” by Brinson, Hood, and Beebower (1986). This study found that market timing accounted for less than 2% of the variation in returns among pension funds. See also, e.g., “Market Timing and Risk Reduction in the USA” by Chang and Lewellen (1984). This study found that even the most sophisticated market timing strategies failed to deliver consistent returns.
xii Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical research. The Journal of Finance, 25(2), 383-417.
xiii See, e.g., Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. Journal of Finance, 25(2), 383-417; Fama, E. F. (1991). Efficient capital markets: II. Journal of Finance, 46(5), 1575-1617; Jensen, M. C. (1978). Some anomalous evidence regarding market efficiency. Journal of Financial Economics, 6(2-3), 95-101; Malkiel, B. G. (1973). A random walk down Wall Street. W.W. Norton & Company; Samuelson, P. A. (1965). Proof that properly anticipated prices fluctuate randomly. Industrial Management Review, 6(2), 41-49.
xiv Sheeraz Raza, Cliff Asness — Smart Beta: The Siren Song of Factor Timing, ValueWalk (Feb. 2, 2020).
xv In addition to the Fama-French six factors, other factors worthy of consideration, per a review by the authors of the academic research, appear to be term factor, credit quality factor, low-volatiity factor, and carry factor. Leading papers supporting these factors include, but are not limited to:
- Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. Journal of Finance, 47(2), 427-465.
- Jegadeesh, N., & Titman, S. (1993). Returns to buying winners and selling losers: Implications for stock market efficiency. Journal of Finance, 48(1), 65-91.
- Novy-Marx, R. (2013). The other side of value: The gross profitability premium. Journal of Financial Economics, 108(1), 1-28.
- Asness, C. S., Frazzini, A., & Pedersen, L. H. (2012). Leverage aversion and risk parity. Financial Analysts Journal, 68(5), 47-59.
- Campbell, J. Y., & Shiller, R. J. (1991). Yield spreads and interest rates: A bird’s eye view. Review of Economic Studies, 58(3), 495-514.
- Altman, E. I. (1989). Measuring corporate bond mortality and performance. Journal of Finance, 44(4), 909-922.
- Koijen, R. S. J., Moskowitz, T. J., Pedersen, L. H., & Vrugt, E. B. (2018). Carry. Journal of Financial Economics, 127(2), 197-225.
- Baker, M., Bradley, B., & Wurgler, J. (2011). Benchmarks as limits to arbitrage: Understanding the low-volatility anomaly. Financial Analysts Journal, 67(1), 40-54.
- Ang, A., Hodrick, R. J., Xing, Y., & Zhang, X. (2006). The cross-section of volatility and expected returns. Journal of Finance, 61(1), 259-299.
xvi Fama, E. F., & French, K. R. (1992). The Cross‐Section of Expected Stock Returns. The Journal of Finance, 47(2), 427-465; Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3-56.
xvii Novy-Marx, R., 2013 “The Other Side of Value: The Gross Profitability Premium”. Journal of Financial Economics, Vol 108, No. 1, pp. 1–28; Fama, E.F., and French, K.R., 2015. A Five-Factor Asset Pricing Model. Journal of Financial Economics, 116(1), pp. 1-22.
xviii The investment factor appears to have first been noted by Titman, S., Wei, K. J., & Xie, F. (2004). Capital investments and stock returns. Journal of Finance, 59(6), 1639-1665.
xix Key papers on the momentum factor include:
- Jegadeesh and Titman (1993): This seminal paper, titled “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” is considered the foundation of momentum research. The authors document that past winners tend to outperform past losers, challenging the efficient market hypothesis ¹ ².
- Jegadeesh and Titman (2001): In their follow-up paper, “Profitability of Momentum Strategies: An Evaluation of Alternative Explanations,” the authors examine various explanations for the momentum effect, including risk-based and behavioral factors.
- Carhart (1997): Mark Carhart’s paper, “On Persistence in Mutual Fund Performance,” introduces the momentum factor as a key component of a four-factor model, which also includes market, size, and value factors.
- Asness, Moskowitz, and Pedersen (2013): This paper, “Value and Momentum Everywhere,” documents the presence of momentum in various asset classes, including stocks, bonds, and commodities.
- Barroso and Santa-Clara (2015): The authors of “Momentum and the Cross-Section of Stock Returns” examine the relationship between momentum and stock returns, finding that momentum is a significant predictor of future returns.
xx Fama, E. F., & French, K. R. (2018). Choosing factors. Journal of Financial Economics, 128(2), 257-279.
xxi John Cochrane of the University of Chicago coined the term “zoo of factors” in his 2011 presidential address to the American Finance Association. Cochrane, John H. 2011. “Presidential Address: Discount Rates.” Journal of Finance, vol. 66, no. 4 (August):1047-1108.
xxii Swade, Alexander and Hanauer, Matthias Xaver and Lohre, Harald and Blitz, David, Factor Zoo (.zip) (October 18, 2023).
xxiii Vanguard Research (2015). “The Global Case for Strategic Asset Allocation (and a Disciplined Rebalancing Approach).”
xxiv Bouchey, P., Nemtchinov, V., Paulsen, A., Stein, D.M., 2012. Volatility Harvesting: Why Does Diversification Work? Investments & Wealth Monitor, Sep/Oct, pp. 19-25.
xxv Constantinides, G. M. (1979). A theory of the optimal timing of portfolio adjustments. Journal of Finance, 34(4), 851-866. See also Fernandez-Perez, A., Frijns, B., & Tourani-Rad, A. (2017). The rebalancing premium. Journal of Financial Economics, 125(2), 333-347. See also Moreno, M., & Navas, J. F. (2017). Rebalancing strategies for portfolio optimization. Journal of Economic Dynamics and Control, 75, 131-145.
xxvi Bogle, J.C., 2009. Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor. John Wiley & Sons.
xxvii Mutual Fund Fees, Risk-Taking, and Performance Persistence (2020) by Nava Ashraf, Olivia S. Mitchell, and Suman Nath.
xxviii See, e.g., Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 55(2), 773-806. Also see, e.g., Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-292.
xxix See, e.g., Bacon, C. (2013). “Behavioral finance and investment policy statements.” Journal of Wealth Management, 16(2), 8-15. This article discusses how a well-crafted IPS can help investors overcome behavioral biases such as loss aversion and overconfidence. See also, e.g., Kinniry, F. M., & Buckley, J. (2017). “The role of investment policy statements in mitigating behavioral biases.” Journal of Financial Planning, 30(6), 142-153. This article highlights the importance of IPS in mitigating behavioral biases such as confirmation bias and anchoring bias. See also, e.g., Statman, M. (2011). “Behavioral finance and investment policy statements.” Journal of Behavioral Finance, 12(2), 63-71.
xxx See, e.g., Graham, B., & Dodd, D. (1934). Security Analysis: Principles and Technique. McGraw-Hill. In this classic book, Benjamin Graham and David Dodd discuss the importance of valuation in investment decisions. They argue that investors should focus on buying assets at reasonable prices, rather than chasing high returns based on past performance. See also, e.g., Campbell, J. Y., & Shiller, R. J. (1998). Valuation ratios and the long-run stock market outlook. Journal of Portfolio Management, 24(2), 11-26. In this paper, John Campbell and Robert Shiller investigate the relationship between valuation ratios (such as price-to-earnings) and long-term stock market returns. They find that high valuation ratios are associated with lower subsequent returns.
xxxi See, e.g., Goyal, A., & Welch, I. (2008). A comprehensive look at the empirical performance of equity premium prediction. Review of Financial Studies, 21(4), 1455-1508. In this paper, Amit Goyal and Ivo Welch examine the performance of various equity premium prediction models, including those based on valuation metrics. They find that none of the models are able to consistently predict future returns. See also, e.g., Campbell, J. Y., & Thompson, S. B. (2008). Predicting excess stock returns out of sample: Can anything beat the historical average? Review of Financial Studies, 21(4), 1509-1531. This study by John Campbell and Samuel Thompson finds that it is difficult to predict excess stock returns out of sample, even using a wide range of valuation metrics and other predictors.
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