What is evidence-based investing?

What is evidence-based investing, and what can investors learn from it?

When we talk about evidence-based investing, what we are really referring to is academic evidence. Some financial professionals dismiss academic research as too theoretical and too far removed from the realities of today's markets. But while academic models are theoretical by nature, that does not mean investors can't draw powerful, practical lessons from them.

In this video, Gerard O'Reilly of Dimensional Fund Advisors explains how academic models, precisely because they simplify the world, help investors understand it better. A good model strips reality back just enough to be understandable, while remaining real enough to be useful. The result is better frameworks for making rational investment decisions and structuring portfolios in the real world.

You'll learn why Dimensional is possibly unique among asset managers in basing everything it does on empirical evidence, and how the firm has worked closely with some of the most celebrated names in academic finance, including Nobel laureates Eugene Fama, Robert Merton and Myron Scholes, along with Fama's long-time collaborator Kenneth French. Their work has shaped Dimensional's understanding of how prices reflect information, how to think about lifecycle finance, and how to structure portfolios intelligently.

Gerard O'Reilly also explains the famous Fama and French Three-Factor Model and its updated Five-Factor Model, which show how certain types of stocks (such as small-cap stocks, value stocks, and shares in highly profitable companies) have tended to outperform the market as a whole over the long term. The core intuition is simple: lower prices and higher expected cash flows point to higher expected returns.

The takeaway: you don't need a detailed grasp of Fama and French's work to benefit from it, but it pays to use an adviser who does. Academic research offers genuine, practical insights that ordinary investors can put to work.

Chapters / Key points

• What evidence-based investing actually means
• Why academic models, though simplified, offer real-world insight
• How Dimensional Fund Advisors builds everything on empirical evidence
• The Nobel laureates and academics behind the approach
• The Fama and French Three-Factor and Five-Factor Models explained
• Why small-cap, value and high-profitability stocks have outperformed long term
• What an evidence-based portfolio looks like
• Why it pays to use an adviser who understands the research

Transcript

What is evidence-based investment?

RP: When we talk about evidence-based investing, what we're really referring to is academic evidence. Some financial professionals are dismissive of academic research, arguing that it's too far removed from the realities of today's financial markets. True, academic models are, by their nature, theoretical. But that doesn't mean investors can't learn practical lessons from them.

Here's Gerard O'Reilly from Dimensional Fund Advisors.

GO'R: Academics come with models of the world, and those models are usually incomplete. But what do you learn from the models? You gain insight about the real world. The models have to be incomplete for you to learn from them, but you do learn. You can gain insights about better ways to invest, better ways to structure portfolios, so that when you come to the real world, you're better equipped and have better frameworks to make rational investment decisions.

So academia, by its nature, has to simplify the real world so that you can understand the real world better. But that's the beauty of how academics approach the problem: they simplify it just enough so that it's real enough to be interesting, but understandable enough so that you learn something.

RP: Dimensional is possibly unique among asset managers in that everything it does is based on empirical evidence. Over the years, the firm has worked with some of the most famous names in academic finance.

GO'R: Gene Fama, who won a Nobel prize a few years ago, is an academic that we have been very closely related to since the founding of the firm. Along with Ken French, who's a co-author and a very close collaborator with Gene Fama. And what we've used from their work, and they have shared their work with us and the world over time, is really the intuition that their work has given to us about prices, securities prices reflecting information.

Other academics are academics like Robert Merton, who also won a Nobel Prize, Myron Scholes has also won a Nobel prize, and their work has also given us tremendous insights, whether it's in lifecycle finance or in how to structure portfolios. So they're to name just a few of what I would call some of the great academics in finance, and there's many more that we're associated with and that we work with. But the work that they have done has really led to some big innovations in the field of practical investing that I think Dimensional has been able to use to the benefit of our clients.

RP: The most famous contribution that Fama and French have made to our understanding of the financial markets is the so-called Three-Factor Model, and an updated version, the Five-Factor Model. In a nutshell, Fama and French have shown how certain types of stocks, for example small-cap and value stocks, and stocks of firms with high profitability, tend to outperform the market as a whole over the long term.

GO'R: We think that there are differences in expected returns across stocks and across bonds. How do you identify those? With the intuition from the Three and Five-Factor Model. Lower price, higher expected cash flows, higher expected returns. So, we say, "How do we structure portfolios?" Let's look for low-priced stocks relative to some fundamental measure of firm size, high expected cash flow, i.e. high profitability. That's higher expected returns, so we overweight those stocks.

RP: It's not necessary for investors to have a detailed understanding of the work of Fama and French, but it pays to use an adviser who does have that level of knowledge. Academic research really does provide us with insights that you, as an investor, can benefit from.