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Conventional vs. Evidence-Based Investment Strategies

I wanted to give a quick rundown of the broad styles of investment management as well as outline the method I use to manage investments.  These two styles are generally called active and passive, but I prefer the terms conventional and evidence based as it more accurately describes each process.  So, let’s get into the tenets of each style and I’ll explain why I believe in the evidence-based approach over conventional.

Conventional-This approach, also called active, has been around since the stock markets, and relies on the investment manager making predictions either on what the stock market will do or what stocks are underpriced.  In the early years of the stock market, this was more effective as the amount of information about how markets act was incredibly limited and those who had access to it had a big advantage. However, because the markets have greatly increased their complexity and with the amount of information that can be found with a cursory google search, that advantage of having more knowledge has evaporated.  Because this style relies on prediction and information not currently reflected in market prices, it becomes incredibly difficult to be successful on a long term basis given how often the “winning” stock, or asset class, or international market changes from year to year. Conventional managers tend to charge more to their clients because of how often they make changes to clients’ portfolios as they buy and sell stocks before the market has time to react accordingly.  

Evidence-Based-This approach has focused more on taking the clients’ goals and creating a portfolio that gives them the best chance of hitting those targets while generating as few fees as possible.  It is characterized most generally as a “buy and hold” strategy, where you create the portfolio and do some occasional rebalancing but essentially leave it alone to grow along with the market.  One of the most recognizable investments that falls into this strategy is the index fund, which has come into the limelight in the recent past. An index fund allows you to buy every stock in a given index, such as the S&P 500, and partake in the growth of that index.  This is a good way for people who are new to investing start to get involved as it provides diversification and is relatively simple to understand. Index funds tend to be low cost and require very little daily management, which keeps management costs low as well. A downside of index funds is that they are very rigid, with rebalancing occuring when the index rebalances, which is usually once a year.  

For those who are a bit more experienced or want more intentional investments, I work with Dimensional Fund Advisors, which has built their investment strategies on the work of Nobel Prize winning economists who sought to understand what dimensions of the market generate higher than average returns over the long term.  By utilizing this research, they have developed a method to capturing higher premiums while providing much broader diversification as they are not limited by individual indices like an index fund. Their expenses are a bit higher than the index fund, but abide by the same theory that market timing is largely impossible and not trying to chase returns from “winning” stocks.  The research has shown that certain sectors outperform others over the long term, so they tilt towards those stocks and away from other sectors, and are able to rebalance daily to get the best prices when buying or selling. For those with long time horizons and interested in something more complicated for higher returns, I greatly encourage you to look into Dimensional funds.  

I know this is a lot of information and I could go on, but I wanted to give a brief(ish) snapshot of the differences between these strategies.  Conventional relies on predicting winners, and evidence-based relies on the effectiveness of the market and taking advantage of long time horizons.  If there is anything you want more information about, comment or send me an email and I’d be happy to clarify or go into greater detail.

Investment Strategy for Doctors