Do You Want the Sizzle or the Science?

Sam Swift, CFA, CFP®, AIF®

Jul 6, 2017

By Lori Booth-Houle, CPA, CFP®

Let’s face it—science isn’t always sexy.   After all, when was the last time you heard of someone binge-watching the “NOVA” TV series on PBS?  Sometimes our brains just want the sizzle, rather than the science.  And I’ll admit that when I’m waiting in the dentist’s office, there’s at least a 50% chance I will pick up the well-thumbed “People” magazine from a side table instead of pulling out my latest copy of the “Journal of Financial Planning” (which is usually very interesting but admittedly low on the sizzle-scale).

Sizzling or not, science and the evidence derived from it have a pervasive and important impact on our lives.  We embrace science each time we call a friend on our cell phone, undergo a medical procedure, board an airplane, or do a Google search.   Yet there is one area of our lives where a vast amount of scientific evidence exists but is overlooked by the multitudes, and that area is investing.

Much of the investment industry, in its current form and as it is promoted in advertising and the media, is a tangle of myths, urban legends, and yes, I’ll say it–fake financial news, all of which support a flawed narrative that not only misleads investors, but actually prevents them from reaching their goals.

This narrative tells us that in order to achieve success as an investor, we must know a number of proprietary secrets, including:  How to pick “hot” stocks; where to place concentrated bets in the “right” sectors; and when to head for the exits to escape the next big crash.   Fear and greed are seductive stories and they sell, which may explain the fact that Jim Cramer’s “Mad Money” TV show has run successfully for just over 12 years (and which, perhaps not coincidentally, is a tenure equaled by “Star Search” and “Lifestyles of the Rich and Famous”).

What the popular narrative doesn’t tell us is this:  The scientific evidence generated in recent decades demonstrates that it is extremely difficult to profit by picking individual securities, timing the purchase and sale of them, and trying to forecast the movement of the markets.  The science tells us that those who follow these strategies take on unnecessary risk, pay higher investment costs, and fail to exceed or even match market returns.  And science points to a better way, called “evidence-based investing.”  But still, you ask…where’s the sizzle?

Science requires thought leaders, and there are many luminaries who have contributed to the field of evidence-based investing.  One of the most important has been Eugene Fama, who started his pioneering research in the 1960’s and was awarded the Nobel Prize in Economics in 2013.  Fama is often called “The Father of Finance” for his body of work on portfolio theory, asset pricing, and stock market behavior.  His groundbreaking work inspired the founding in 1981 of Dimensional Fund Advisors, the evidence-based mutual fund company that TCI and its clients know and love.

Another contribution by Fama:  His research, co-authored with Ken French, was the basis for the Fama/French three-factor model, which has dominated academic finance for almost three decades.  The Fama/French model identified a number of factors or “dimensions” in equity and fixed income markets that persistently lead to higher expected returns over longer periods of time.  An investor who incorporates these factors into mutual fund portfolios knows that this is not about picking individual companies or sectors—it’s about holding a broadly diversified group of securities that emphasize these dimensions identified by validated research.

Thanks to the work of Fama and other financial scientists and academicians, there now exists an entire framework for evidence-based investing.  This process says—tune out the noise of the myths, urban legends, and fake financial news, because there is a better way, and it’s based on science and evidence.

There’s a lot of meat to evidence-based investing, but it’s really not that complicated—the framework is built around things we can control, such as:  A disciplined asset allocation suitable to your risk tolerance, broad global diversification that emphasizes those factors or dimensions that offer higher expected returns, low investment costs, tax efficiency, and prudent rebalancing.

Now tell me you don’t see at least a little sizzle here, especially when you read the phrase, “higher expected returns.”  We all want those!  Science may not be sexy, but it’s verifiable and it works.  So when it comes to investing, forget the sizzle–there is a better way.  It’s called evidence-based investing, which can be expressed with this highly technical, scientific formula I just made up:   Eugene Fama > Jim Cramer.


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