The Case For Evidence-Based Investing, Part III - A Review Of The Supporting Literature

by: EB Investor

There is an alternative to speculating in stocks; it is called evidence-based investing. Evidence-based investing is backed by academic research going back to the 1500s.

I will review why investors should consider evidence-based investing and why it is the best investment strategy for long-term investors.

Evidence-based investing is the best investment strategy for the average investor and the wealthy alike, because it relies on evidence and data, rather than hunches or predictions.

John Bogle has been on the side of the individual investor for many years. His work in creating index funds has given the average investor a fair chance at reaping the benefits of investing in capitalism and attaining financial freedom. Many will contend that index fund investing is un-American or it is dangerous to capitalism.

Yet, the reality is that I can think of nothing more American than believing in the power of free markets. The index investor is not relying on the "superior" talents of an active manager to interpret the information that all other active managers have and find an edge that somehow all the other highly qualified active managers have missed. Instead, the index investor is putting their faith in the market to harness the returns of capitalism and provide the investor with all the appreciation and dividend income the market has to offer. If you are still not convinced that you should be following Warren Buffett and investing the majority of your money passively, this video will hopefully convince you before we move forward in the case for evidence-based investing.

Reviewing the Research

"Anchor every decision in data and the rest will follow."

- Larry Page, Co-Founder, Alphabet, Inc.

Through the years, many individuals have contributed to what we know about financial markets. Giants of the investment world such as Harry Markowitz, Myron Scholes, Eugene Fama, and Kenneth French have been at the forefront of advancing our knowledge of markets and contributing to the knowledge we have on investing. It is these academic breakthroughs that have given rise to a new, more intelligent way to invest; relying on evidence rather than emotion. Buying the market is the most intelligent way to invest, backed by over 500 years of academic research.

The Foundation: Market Efficiency

Are markets efficient? This debate is one of the most exciting and contentious in all of finance. The literature on this concept is so diverse one can easily make a case for market efficiency or inefficiency depending upon which studies one focuses. However, when you dig deeper, you can see the weight of the evidence tilting towards market efficiency. Here is just a sampling of the research supporting market efficiency.

- Girolamo Cardano (1564) wrote about tracing the origins of market efficiency begins in Italy, with the publication of "Liber de Ludo Aleae" (The Book of Games and Chance). He touched on many concepts that would later become the rules of probability.

- In 1863, a French stockbroker, Jules Regnault, observes that the longer you hold a security, the more you can gain or lose on its price variations, thus the price deviation is directly proportional to the square root of time.

- Lord Rayleigh (1880), a British physicist, was aware of a random walk, later John Venn, the British logician and philosopher, would build on this work by gaining an understanding of a random walk as well as Brownian motion. (Venn, 1888)

- George Gibson (1889) wrote the book, "The Stock Markets of London, Paris, and New York", mentioning the concept of efficient markets. Gibson wrote, "when shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them."

- French Mathematician Louis Bachelier (1900), published his Ph.D. thesis, "The ́orie de la Speculation", which discussed the use of Brownian motion in evaluating stock options. His work was far ahead of his time and would lie dormant until it was rediscovered later in the 20th century. Further work by Taussig (1921), MacCauley (1925), Olivier (1926), and Mills (1927) would further the knowledge of mathematical finance. MacCauley observed a striking similarity between the stock market and a chance curve. Olivier provided proof of the leptokurtic nature of the distribution of returns. Finally, Mills wrote "The Behavior of Prices" which proved the leptokurtosis of returns.

- Cowles (1933) proved for the first time that stock market forecasters cannot forecast, and in a follow up study in 1944, found that professionals cannot beat the market either.

- Jack Treynor (1962) wrote the first paper on the Capital Asset Pricing Model. This was followed by Sharpe (1964), who published his Nobel Prize winning work on the Capital Asset Pricing Model or the CAPM.

- Fama (1965) defined an efficient market for the first time in his empirical analysis of stock market prices in which they conclude that they follow a random walk.

- Samuelson (1965) provided the first real arguments for efficient markets in his paper, "Proof", that properly anticipated prices fluctuate randomly.

- Harry Roberts (1967) coined the term efficient market hypothesis and made the distinction between weak and strong form tests, which became the classic taxonomy in Fama (1970).

- In 1968, Michael C. Jensen evaluated the performance of mutual funds and concluded that "on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses". Ball and Brown (1968) were the first to publish an event study.

- Fama et al. (1969) undertook the first ever event study (although they were not the first to publish), and their results lend considerable support to the conclusion that the stock market is efficient.

- Published in 1970, the definitive paper on the efficient markets hypothesis is Eugene F. Fama's first of three review papers: 'Efficient Capital Markets: A Review of Theory and Empirical Work' (Fama, 1970). He was also the first to consider the 'joint hypothesis problem'. Granger and Morgenstern (1970) published the book, "Predictability of Stock Market Prices".

- Scholes (1972) studied the price effects of secondary offerings and found that the market is efficient except for some indication of post-event price drift.

- Samuelson (1973) wrote his survey paper, 'Mathematics of speculative price'.

- LeRoy (1973) showed that under risk-aversion, there is no theoretical justification for the martingale property.

- Lorie and Hamilton (1973) published the book, "The Stock Market: Theories and Evidence". Also in 1973, Burton G. Malkiel first published the classic, "A Random Walk Down Wall Street" (Malkiel, 1973), now in its tenth edition.

- Samuelson (1973) generalized his earlier (1965) work to include stocks that pay dividends.

- Ellis (1975) published the article, "The Losers Game", in the Financial Analysts Journal. The investment management business (it should be a profession but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.

- Brinson, Singer, Beebower's (1991) "The Determinants of Portfolio Performance II, An Update, Financial Analysts Journal", found that asset allocation determines 91% of a portfolios return.

- Malkiel (2003) examined the attacks on the EMH and concludes that stock markets are far more efficient and far less predictable than some recent academic papers would have us believe.

- Malkiel (2005) showed that professional investment managers do not outperform their index benchmarks and provides evidence that by and large market prices do seem to reflect all available information.

- Andrew Lo (2008) wrote the 'Efficient Markets Hypothesis' article for the second edition of The New Palgrave Dictionary of Economics.

- Yen and Lee (2008) presented a survey article that gives a chronological account of empirical findings and conclude that the EMH is here to stay.

- In a paper on the global financial crisis, Ball (2009) argued that the collapse of Lehman Brothers and other large financial institutions, far from resulting from excessive faith in efficient markets, reflects a failure to heed the lessons of efficient markets.

Exploring Market Efficiency

As you can see, the notion of an efficient market that incorporates available information has been assembled progressively through time. The advancement of knowledge on the subject led Harvard financial economist Michael Jensen to state that "there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis" (Emphasis mine).

Saying markets are efficient is not enough; we have to dig deeper to understand what kinds of information the model is saying are included in securities prices, and what advantage, if any, can be achieved by investors seeking to deviate from the passive market portfolio.

There are three forms of market efficiency.

Weak Form Efficiency

Weak form market efficiency states that the historical price information only is incorporated into securities prices. Meaning no one can detect mispriced securities and beat the market. However, many who attempt to engage in technical analysis are doing just that, attempting to study the past to predict the future of a given security or the market as a whole. The evidence supporting this form of market efficiency is strong while the records of those practicing this form of active speculation are pretty dismal.

Semi-strong Form Efficiency

The semi-strong form of market efficiency suggests that the current price of a security represents all the available public information. This includes all information regarding past prices, as well as data contained in financial statements, company announcements, macroeconomic factors, etc. Any piece of information that is publicly known is contained in the market price. The theory contends that because the information is public and is known to all investors, there is thus no opportunity to gain an edge, as soon as the information is made public it is reflected in the securities price. The evidence for semi-strong form efficiency is quite robust.

Strong Form Efficiency

The strong form of market efficiency is the notion that all public and private information is contained in securities prices. However, the research on strong form EMH is mixed.

Reconciling Behavioral Theories with Efficient Markets

The discussion above, besides being fascinating to those of us that love economics and finance, is a great discussion about market efficiency. It illuminates the many challenges from behavioral theory and answers those challenges with evidence.

The efficient market hypothesis is a model which seeks to explain securities prices. While the market is largely efficient, small inefficiencies still exist, as supported by the research of many of the behaviorists such as Lakonishok, Shiller, and Thaler, who believe that the market is largely driven by psychological phenomena. Their work, however, does not disprove the model of efficient markets.

EMH adherents concede the existence of psychological factors but fail to see how they get incorporated into securities prices. Reviewing the research on both of these theories, I have come to believe that markets are efficient, in the sense that all available information is incorporated in securities prices, and while I concede that market prices can be bid up or down by psychological modalities of market participants, this is completely consistent with the parameters of efficient market theory. There is simply no evidence to support the behaviorists theory to a sufficient degree that one would discard the notion of efficient markets. Many would contend that the overreaction and under reaction to information proves that markets are inefficient. The 2008 financial crisis is a great example of this.

Dr. Fama clearly addressed these issues in his 1998 paper in the Journal of Financial Economics entitled, "Market efficiency, long-term returns, and behavioral finance". In this paper he states:

...many of the recent studies on long term returns suggest market inefficiency, specifically, long-term under reaction or overreaction to information. It is time, however, to ask whether this literature, viewed as a whole, suggests that efficiency should be discarded. My answer is a solid no, for two reasons.

First, an efficient market generates categories of events that individually suggest that prices over-react to information. But in an efficient market, apparent under reaction will be about as frequent as overreaction. If anomalies split randomly between under reaction and overreaction, they are consistent with market efficiency. We shall see that a roughly even split between apparent overreaction and under reaction is a good description of the menu of existing anomalies.

Second, and more important, if the long-term return anomalies are so large they cannot be attributed to chance, then an even split between over- and under reaction is a pyrrhic victory for market efficiency. We shall find, however, that the long-term return anomalies are sensitive to methodology. They tend to become marginal or disappear when exposed to different models for expected (normal) returns or when different statistical approaches are used to measure them. Thus, even viewed one-by-one, most long-term return anomalies can reasonably be attributed to chance."(Fama, 1998)

For a more thorough refutation of the behavioral theory, I recommend investors read the full paper. Dr. Fama goes into a great deal of detail proving the strength of the efficient market theory, and more than answers the challenge of many studies by behavioralists.


The evolution of research in finance has been remarkable. In just a short period of time, we have progressed from a one factor Capital Asset Pricing Model (CAPM) which focused solely on risk, measured as beta, to the current model proposed by Eugene Fama (Chicago), and Kenneth French (Dartmouth) which employs a five factor model for making investment decisions. Fama and French have revolutionized investment management with the five factor model, focusing on not just risk exposure but also market capitalization, investment style, profitability and finally management investment as measures of long-term investment performance.

The five factor approach brings decades of investment research in portfolio management to individual investors and institutional investors alike, allowing for the implementation of an intelligent investment strategy that results in better performance outcomes over a full investment cycle. I will explore the multi factor model further in Part IV.

Mathematical finance has clearly proven through the decades that the odds of an active manager beating the index are purely randomized. Going back to the mathematical models of Cardano in 1564 all the way through to the recent writings of Fama, Bogle, Ellis, and Malkiel, there is simply no mathematical proof for the superiority of active management. The notion that securities can be selected and an investor can outperform a passive index fund, which is holding the market portfolio, is no more likely than can be explained by random chance, in most cases.

Therefore, the only way for an investor to truly increase their return is to hold a portfolio that deviates meaningfully from the market portfolio. Not necessarily through the active selection of securities, but rather through the tilting of the portfolio towards the identifiable sources of outperformance. In the next piece, I will review the multi factor model and the concept of portfolio optimization, and in the final piece, I will explore the role of active managers and quantitative tools to analyze luck versus skill in portfolio management.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.