How to Think About Evidence-Based Investing

02/02/2025  I recently read a LinkedIn post where the author back-tested a mixed-bag of assets, creating a portfolio that outperformed a ‘60/40’ portfolio over several years, for equivalent volatility and without changes to the asset allocation.   

The suggestion was that, therefore, the term Evidence-Based Investing (EBI) is little more than a marketing phrase.  Engagement and vigorous discussion ensued.

There is no doubt that “EBI” does get used as a marketing device.  Much like “fat free”, “sustainable”, or “clinically proven”.  There is an implicit desirability in the term, but it may not mean what we think it means.   

EBI does not mean that index-trackers are always best, or that we should always choose the lowest cost ETF (exchange traded fund), or that a 60% equity / 40% bond portfolio is the right one for us.

No, these statements are concerned with implementation of investment strategy, and are (or should be) self-evidently too prescriptive to be blindly applied.

"Evidence-Based Practice"

According to Wikipedia:

Evidence-based practice is the idea that occupational practices ought to be based on scientific evidence. The movement towards evidence-based practices attempts to encourage and, in some instances, require professionals and other decision-makers to pay more attention to evidence to inform their decision-making. The goal of evidence-based practice is to eliminate unsound or outdated practices in favor of more-effective ones by shifting the basis for decision making from tradition, intuition, and unsystematic experience to firmly grounded scientific research.

Witchdoctors?

I use the progress of modern medicine as an example of how evidence-based practice improves outcomes.  The use of leeches for bloodletting was still common until the late 1800s, by which time evidence showed it to be ineffective against disease.  Medical science progressed in other directions – such as the development of germ theory by Louis Pasteur.   

Witch-doctors - magical practitioners paid for spells and potions that have no positive impact on outcomes - have all but disappeared.  From the medical field.  

Where does ‘Evidence-Based’ fit into the Investment Process?

I was introduced to the concept of “first principles” as a young engineer.  First principles are the basic truths that underlie a particular field of knowledge.  They are not derived from other statements, and stand alone as self-evident truths.  The current flowing through a conductor is proportional to the potential difference (voltage) between the two points, and inversely to its resistance.  You must sample a signal at twice it’s bandwidth to not lose information.  And so on.

First principles are the foundation from which more complex ideas and theories are developed.  They are observed directly, or are derived by scientific procedure.  Sir Peter Medawar, 1960 Nobel Prize winner for joint discovery of acquired immunological tolerance, put it thus:

"Scientific discovery, or the formulation of scientific theory, starts in with the unvarnished and unembroidered evidence of the senses. It starts with simple observation—simple, unbiased, unprejudiced, naive, or innocent observation—and out of this sensory evidence, embodied in the form of simple propositions or declarations of fact, generalizations will grow up and take shape, almost as if some process of crystallization or condensation were taking place. Out of a disorderly array of facts, an orderly theory, an orderly general statement, will somehow emerge."

In the field of investment, we can agree that real-world evidence and sound first principles make a good foundation.  From there, we build our generalised investment framework, a philosophy of core tenets which help guide the investment process.  We don’t need many – they can be few, but fundamental.  

We note that famous investor Warren Buffett seems to rarely comment on analysis of technical factors – his most-quoted words of wisdom tend to be philosophical.  They happen to make good sound-bites, but they have been formulated from decades of experience and deep thinking.  Like in other areas of life, we’re less likely to make serious errors if we have good core philosophies and a framework for decision-making.

No Theory? = Not Evidence-Based

Let’s return to the discussion about a back-tested mixed-bag portfolio that historically outperformed a 60/40.  To go from foundation, Medawar’s “unembroidered evidence of the senses” to framework, “orderly general statement”, requires a thesis.  Anyone can use hindsight to build a portfolio of assets that outperformed a certain benchmark over a certain period of time.  But by itself this tells us nothing.

We connect evidence to theory by formulating hypotheses to be tested against the evidence.  This process helps to identify gaps in current knowledge, and to propose explanations that can be examined empirically.  The mixed-bag portfolio has not been subjected to this hurdle. It doesn't qualify as evidence-based for the purpose of investment strategy.

The "60/40" Portfolio: Evidence-Based Because We Have The Thesis

In contrast, the thesis behind the 60/40 (in the generic sense) is strong.  Generally, though not always (of course), equities and bonds have low correlation; so the two classes together make a decent minimal core portfolio. 

Furthermore, as shown by James X. Xiong, Roger G. Ibbotson, Thomas M. Idzorek, and Peng Chen, in “The Equal Importance of Asset Allocation and Active Management”, (1 March 2010 Financial Analysts Journal Volume 66, Issue 2), approximately 75%-80% of total portfolio returns were explained by overall market movement – not by detailed asset allocation or active management.  If we have a passive global equity core, we will capture much of overall market gains.

This is reinforced by understanding the relatively high correlations between different equity sub-classes and regions.  Given the economic dependencies across the world, it’s hardly a surprise that global equity markets often behave in lockstep with each other.  

Thus, a single global equity index tracker is a decent core holding, without concern for additional ersatz diversification.  And in similar manner, we can select a single quality bond index tracker as the 40% to equity’s 60%.

Evidence-Based Investing is a Way of Thinking

Evidence-based investing is not prescriptive, it is a process, a scientific way of thinking about investment.  Like medicine, it will continuously evolve over time, as new research and discoveries emerge.  

I see the 60/40 portfolio as a kind of ‘proof of concept’ for EBI, ready to be built upon and developed as new theses are proposed.  Except in rare situations, it should not be seen as a fully-formed portfolio by itself.