Stordahl Capital Management’s Evidence-Based Investment Insights: Insight #10: What Has Evidence-Based Investing Done for Me Lately?
Welcome to the next installment in our series of SCM’s Evidence-Based Investment Insights: What Has Evidence-Based Investing Done for Me Lately?
In our last piece, “Factors That Figure in Your Evidence-Based Portfolio,” we introduced three key stock market factors (equity, value, and small-cap) plus two more for bonds (term and credit). These five factors have long formed a backbone for many evidence-based portfolios.
Does this mean we have everything we need to know to build better portfolios? Hardly!
The Benefits of Evolving Evidence
Continued research has helped us identify additional market factors with additional potential premiums. Three of the more prominent among these include investment, profitability, and momentum:
The investment factor: Companies that reinvest heavily to sustain profitability tend to deliver lower returns than those that distribute more net cash flow to shareholders.
The profitability factor: Companies with higher profitability have delivered premium returns over those with lower profitability.
The momentum factor: Stocks that have performed well or poorly in the recent past tend to continue to do the same for longer than random chance seems to explain.
Ongoing analysis has also helped us fine-tune how to pair new and existing factors judiciously. For example, as described in a Dimensional Fund Advisors 2023 paper, “The Evolution of Small Cap Investing,” small-cap investing may be improved by avoiding downward momentum when trading and filtering out small companies with relatively low profitability, high reinvestment costs and/or minimal cash flows.
Factoring for Alternatives
Beyond stock and bond market investments, another ongoing inquiry involves looking at investable assets from other markets.
Where might we identify investment premiums that can be cost-effectively mined after taxes and trading costs? Where evidence suggests they exist, such as in alternative lending and reinsurance markets, we may be able to use these assets to diversify existing investment portfolios further. In “Reducing the Risk of Black Swans,” Larry Swedroe and Kevin Grogan explain:
“Like with factors, adding alternatives that represent unique sources of risk and return and that offer equity-like expected returns should allow us to lower a portfolio’s allocation to market beta (the riskiest factor), thus creating portfolios with even greater risk parity and even more diversified sources of risk. Because each of the alternatives we have discussed shows low correlations to other portfolio assets, we should end up with a more efficient portfolio — one with similar returns but less risk.”
Sustainable Investing
These days, many investors would also like their investments to contribute, or at least cause less harm to the greater good, while still delivering decent, if not stellar returns.
Ongoing research has also helped here. An evidence-based outlook helps confirm when a sustainable investing theory appears robust. It also suggests when a promising approach may not work out as well as hoped, no matter how well-intended it may be.
The Big Picture of Evidence-Based Investing
We acknowledge we’ve just thrown a lot of information at you in a compact space. Here are five best practices for incorporating new and existing investment factors into your investing:
Take your time: While a “new” factor may or may not have existed for some time, our ability to isolate them is more recent. The evidence-based community has had less time to assess their staying power. Time will tell how persistent they may be. Favor factors with longer, broader, and more durable evidence.
Consider the costs: As touched on before, even if a factor exists in theory, that doesn’t mean it can be implemented in real life. We must capture an expected premium without generating costs beyond its worth.
Balance dueling factors: Sometimes, it can be difficult to incorporate one factor into a portfolio without sacrificing another. Benefits and tradeoffs must be carefully considered at the fund level and for individual goals.
Identify your priorities: How will you balance a desire to invest efficiently and sustainably? Equipped with solid evidence in an often emotionally charged arena, you will be better positioned to make rational choices and informed decisions that best fit your heartfelt values and financial goals.
Don’t forget to diversify: As we covered in earlier Evidence-Based Investment Insights, avoid concentrating too much of your wealth on any given factor, no matter its appeal. Ideal portfolios are still tempered by global diversification based on the risk and return expectations each component has to offer.
How We Can Help
With so much at stake, no wonder opinions vary on when, how, or even if various factors should play a role in your portfolio management.
This is where we believe an evidence-based advisor relationship is critical to your wealth and well-being.
Exciting new investments that erupt overnight based on scant evidence and concentrated events are unlikely reasons to alter a durable investment discipline. Instead, it’s important to reflect on thoughtful questions such as:
Have the results been replicated across factors, over time, and worldwide?
Is there robust analysis, not only from industry insiders but from objective academics?
Has it survived extensive peer review, if not unscathed, at least free of mortal wounds?
All of this takes time. Yet, one needs only glance at daily headlines to become awash in ideas from competing, often conflicting voices of authority. Being informed is helpful; drowning in information overload is not. Too much noise creates perpetual uncertainty, which can strip away all the emotional and performative advantages of a patient, disciplined approach.
We would be happy to speak with you individually about the latest evidence on factor investing and how to apply it to your investment strategies best. We offer a complimentary 15-minute call to answer your questions and to share how we can help.
Your Take-Home
By considering each new potential factor according to strict guidelines, our aim is to extract the diamonds of promising new evidence-based insights from the considerably larger piles of random data. We feel you are best served by heeding those who take a similar approach with their advice.
Next, we turn to a factor we have mentioned but have yet to explore, even though it may be the most influential one of all: you and your financial behaviors.
This information should not be construed as investment, tax, or legal advice. This commentary reflects the personal opinions, viewpoints, and analyses of the Stordahl Capital Management, Inc. employees providing such comments and should not be regarded as a description of advisory services provided by Stordahl Capital Management, Inc. or performance returns of any Stordahl Capital Management Inc. Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this piece constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Accessing websites through links directs you away from our website. Stordahl Capital Management is not responsible for errors or omissions in the material on third-party websites and does not necessarily approve of or endorse the information provided. Users who gain access to third-party websites may be subject to the copyright and other restrictions on use imposed by those providers and assume responsibility and risk from the use of those websites. Please note that trading instructions through email, fax, or voicemail will not be taken. Your identity and timely retrieval of instructions cannot be guaranteed. Stordahl Capital Management, Inc. manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.