How Medical Decision Making and Investing Are Alike

March 4, 2013

Applying the same evidence-based thinking you use in your medical practice can actually create a more efficient investment portfolio for you personally.

When we were in training, we were taught to "look at the literature" to get the latest in treatment methods. We learned to understand how the study was designed so that we could decide if the results were valid. And we learned that when the evidence was overwhelming in one direction, that was probably the best route to take. Interestingly, it is no different with investing. There is a large body of literature based on academic studies of the stock market and investor behavior, and much of it supports the conclusion that Wall Street has it wrong! There is a better way to invest that is consistent with the way you make medical decisions - it can be termed "evidence-based investing."

If you have not had success with do-it-yourself investing and/or with conventional Wall Street approaches, it may comfort you to know that even the pros have trouble. Over the five years ending 2011, up to 83 percent of actively managed public equity funds failed to beat their benchmark index1. And the "average investor" did even more poorly - failing to keep pace with inflation over the 20 years ending 20112. In fact, the average investor - lacking a disciplined strategy - could have earned about three times as much during that period by buying and holding an index fund tracking the S&P 5003. Apparently, few independent investors have the knowledge to effectively choose investments or the willpower to stick with a strategy throughout the wild gyrations of the markets.

The popular press is filled with predictions about where to invest your money, but academic research has shown that it is actually very difficult to consistently make accurate predictions … and probably not worth the increased cost of attempting to do so. In fact, such research, based on more than 80 years of data, has suggested that the securities markets are reasonably "efficient" - the price of a security reflects all available information about the underlying company, and securities analysts cannot consistently identify and capitalize on incorrect prices.

The same academic research - no different in style from the scientific research on which your medical decisions are made - has shown very definite long-term trends:

• The return of stocks as a group has exceeded that of bonds and inflation.

• The return on stocks of small companies has exceeded that of large companies.

• Stocks of financially distressed ("value") companies have outperformed those of fiscally sound companies.

This is the basis of the "three-factor model" of investing4, which predicts that less than 10 percent of the return of a portfolio is due to active security selection and market timing. The remainder is due to asset allocation – how much in stocks, bonds and cash.

These observations are explained by another important lesson of the academics:

• There are certain types of risk that are rewarded and are therefore worth taking.

• Other risks can be decreased through diversification.

In other words, risk and return are related; investors have historically been rewarded for taking on the extra risk of owning stocks, particularly of small and value companies.

How can you take advantage of this information? One approach is to forgo attempts at "beating the market" by constructing a diversified portfolio of securities that seeks to achieve the average returns of all segments of "the market." An efficient way to do this is by selecting no-load mutual funds, each of which is designed to match the performance of a particular asset class - foreign and domestic, large and small, growth and value. To further improve the efficiency of the portfolio, the funds should be managed in a cost-effective and tax-efficient manner to minimize trading costs and capital gains distributions; both of which are passed directly to the investor, reduce return and increase tax liability.

The value-added then comes from having access to all market segments, and in the way these funds are combined to create a portfolio that is less volatile and delivers greater expected returns than the individual components. Success comes as a result of defining and rigidly following a well-thought-out strategy, and resisting the emotional urge to tinker regardless of short-term market fluctuations.

By adhering to these basic academically-based principles - securities markets work, risk and return are related, and costs matter - it should be possible to structure long-term investments in an efficient and effective manner. Those investments then can play a key role in helping you achieve financial independence.

1. Source: Dimensional Fund Advisors

2. Study by Dalbar Inc. as reported by JP Morgan, January 2013

3. The S&P 500® Index is an unmanaged index comprised of the 500 stocks with the largest market capitalizations trading in the United States. The Index does not reflect the deduction of any fees or expenses.

4. Fama, EF and French, KR. 1993. Journal of Financial Economics, 33:3-56.