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Conclusion: The ABCs of Behavioral Biases
During this series, we have learned that our own behavioral biases are often the greatest threat to our financial well-being.
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). Combined, 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 and better portfolios? Hardly!
Continued research has helped us identify additional market factors at play, with additional potential premiums. Three of the more prominent among these include investment, profitability and momentum.
Ongoing analysis has also helped us fine tune how to judiciously pair new and existing factors. For example, as described in a Dimensional Fund Advisors 2023 paper, “The Evolution of Small Cap Investing,” it appears small-cap investing may be improved by avoiding downward momentum when trading, and by filtering out small companies with relatively low profitability, heavy reinvestment costs and/or minimal cash flows.
Beyond stock and bond market investments, another line of 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 further diversify existing investment portfolios. 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.”
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 helped here as well. An evidence-based outlook helps confirm when a sustainable investing theory appears to be robust in reality. It also suggests when a promising approach may not pencil out as hoped for, no matter how well-intended it may be.
We acknowledge that we have 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:
With so much at stake, no wonder opinions vary on when, how or even if various factors should play a role in your own 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 is important to reflect on thoughtful questions such as:
All of this takes time. And yet, one need 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 best apply it to your own investment strategies.
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.
In the next installment of this series, we will 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.
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This post was written and first distributed by Wendy J. Cook.
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