Scientific Method & Investing
“Science is a way of querying the world. It’s a pathway to establishing an objective truth, a truth that exists independent of your opinions, or how you feel about it.” - Neil deGrasse Tyson
By: Cole Conkling
Science, and more specifically, the scientific method is concerned with making sense of the world around us. For example, physics is concerned with the nature and properties of matter and energy. You drop a ball and it falls to the earth. Why and how does this process happen? While it’s distinguishable from other fields of scientific study, such as biology and chemistry, all scientific fields rely on the scientific method to attempt to understand the physical reality around us. This article will take the reader on a brief exploration of science and the scientific method. We’ll then take a small detour to examine science’s application to modern medicine and how its use there resulted in staggering beneficial health outcomes for humanity. We’ll next look at how science eventually leads to technology, or tools and methods by which we can use scientific information and truths to better our lives and the world. Finally, we’ll look at how the scientific method can be used in investing and how the investment industry should use science and the scientific method to provide better outcomes for all investors.
The Scientific Method
The scientific method was first outlined by Sir Francis Bacon in the late 16th and early 17th centuries. The basic steps are: (1) make an observation that describes a problem, (2) create a hypothesis, (3) test the hypothesis, and (4) draw conclusions and refine the hypothesis. Importantly, the scientific method requires verifiability (can it be repeated by others), predictability (is the theory reliable—e.g., dropping a ball under normal conditions should result in that ball falling to the earth), and falsifiability (a horoscope is not falsifiable because a scientist cannot disprove that a Piscean may get a phone call from someone he or she hasn’t heard from in a long time).
The scientific method, in its purest form, is concerned with discovering knowledge about the world based on making falsifiable predictions (hypotheses), testing them empirically, and developing peer-reviewed theories that best explain the known data. Science is always evolving. A study will be published, a theory propounded, and then attacked, ridiculed, refined, rejected, or accepted. Science requires one to show his or her work. Arguments that rely on things like beliefs, feelings, hunches, and “well, I just know it’s right because I say so” do not fly.
Maybe an established theory is eventually rejected over time when the evidence supporting it becomes miniscule or non-existent (the world is flat). A new theory replacing the old then slowly becomes accepted (the world is round). And then maybe that new theory is further refined (the world is spherical). This is the ongoing progress of scientific inquiry. Accepted theories may hold for long periods until proven wrong. New data and theories may quickly redefine entire fields. Eventually a consensus may emerge that becomes generally accepted and largely irrefutable (e.g., the existence of gravity).
Modern Medicine Detour
Medicine has not always been, strictly speaking, scientific. A rough consensus of what worked and did not work was developed through the generations and eventually recorded for posterity (e.g., eat this plant for an upset stomach; take this tincture for a headache). Ancient shamans, medicine men, and the like surely had a degree medicinal knowledge, but their approaches would not today be thought of as “scientific.” Indeed, use of the scientific method in medicine was virtually non-existent until the early 20th century. Many medical treatments once regularly used before are now seen as farcical and barbaric (see, e.g., bloodletting, lobotomies, routine amputations). Things like the placebo effect were unknown and unknowable until the advent of randomized double-blind studies.
A lot of change clearly came from technological advancement. Germ theory—that microscopic organisms cause many human diseases—could not have reasonably been discovered (even through use of the scientific method) until the microscope was invented. Same goes for many medical advancements like the X-ray, anesthesia, and the MRI, which have led to amazing medical advances. But it’s medicine’s use of the scientific method that drastically transformed medicine for the better, and which continues to do so to this day.
Modern medicine (post 19th Century) has always had a pull-and-tug relationship between clinical-based techniques (e.g., what works at the doctor’s office and hospital) and biomedical research (e.g., labs and studies). Clinical practice was typically referred to as the “art of medicine”; evidence-based/scientific research was often not implemented. This changed somewhat recently, in the 1960s, with more focus given to treatment supported by the scientific method. This is now referred to as “evidence-based medicine.”
As general science advanced, the medical community eventually saw that there was a clear disconnect between evidence-based medicine, founded on peer-reviewed research, and traditional, clinical-based medicine, founded on training, experience, and first-hand, bed-side results. The sea-change came when the scientific method became incorporated into clinical decisions making. Health outcomes have increased ever since.
Technology – Using Science to Better our Lives
Science and the scientific method do not live in a theoretical vacuum separate and apart from the real world of everyday people. Instead, the scientific pursuit of truth leads to technology. Ever since humans have explored our world, technology has propelled us forward. From the use of basic tools to aid hunting and gathering to nuclear technology and sending humans into space, technology (or science in action) has been at the forefront. Technology has also greatly shaped today’s investing environment. In the early 20th century, investing in securities was cumbersome and expensive. You had to use a broker dealer that charged outrageous fees, and the concept of index funds and ETFs did not exist. Today, the pictures are drastically different because of technological advances in investment technology. Index funds can be purchase with the click of a button with zero commissions, along with ongoing asset management fees that are close to zero! It has never been easier for individual investors to invest according to the scientific method because of advances in technology.
Science-Based Investing – Why do Most Investors Underperform?
In my mind, the general state of the investment industry today is strikingly similar to pre-evidence-based medicine. It’s akin to medicine in the 1960s when evidence-based techniques were starting to come into favor, but much of the industry was not on board for one reason or another. The part’s that worse, however, is that while medicine eventually succumbed to evidence-based care because it became clear it was best for patient outcomes, the investment industry seems to be ignoring the evidence of what investments are best for client outcomes. Let’s take a closer look.
· Most Investors Underperform the Market
Rigorous, peer-reviewed academic research consistently shows that most investors underperform the market. What exactly is a market? Simply put, a market is the collection of all the interested buyers and sellers for a particular asset. So, for example, all the buyers and sellers of large cap. stocks in the U.S. form a market for those securities. That market is then represented as what we know as the S&P 500. There are markets for commodities, real estate, bonds, and the like. We call investors, or investment strategies, that try to outperform a particular market “active.” Investors and strategies that simply try to replicate a particular market are known as “passive.” Active investors seek “alpha,” or excess returns above and beyond the market’s return. The market’s return is what’s known as “beta.” A truly passive strategy would be 100% beta and perfectly match the return of the market. Most active investors fail to outperform (or “earn alpha”) because of three reasons: (1) The zero-sum game & costs, (2) Efficient Markets & Fierce competition, and (3) Behavioral biases.
1. Zero Sum Game & Costs
The price of an asset within a market is determined by the agglomeration of every trade (i.e., a seller selling and a buyer buying) that takes place. When demand for an asset is strong (i.e., there are more buyers than sellers) the price of the asset increases; when demand for an asset is weak (i.e., more sellers than buyers) the price of the asset decreases. Strong demand increases the price of an asset and attracts more sellers willing to now sell at the higher price than they would have been before when the price was low. Conversely, low demand for an asset means more sellers than buyers, resulting in a drop in price which eventually attracts more buyers who are now willing to buy at the lower price than they would have been before when the price was high.
Since the market return for any asset (e.g., a stock) or a collection of similar assets (e.g., the S&P 500) represents the average return of all investors, for each trader that outperforms the market, there must be a trader that underperforms the market by that same amount such that, in aggregate, the excess return (alpha) of all invested assets equals zero. However, once you add in trading costs, taxes, bid-ask spreads, and the like, the average investor trying to outperform a market actually underperforms. This is why, according to Noble Laureate Eugene Fama out of the University of Chicago, “[a]fter costs, only the top 3% of [professional investment] managers produce return that indicates they have sufficient skill to just cover their costs, which means that going forward, and despite extraordinary past returns, even the top performers are expected to be only as good as a low-cost passive index fund. The other 97% can be expected to do worse.” Owning an index fund that replicates a market is now very inexpensive; almost free. Choosing an active manager trying squeeze out alpha is very expensive.
Many investors pay way too much in fees, costs, and taxes. Many do not even know the true amount of these fees and costs, as a lot of them are not explicitly shown on statements (i.e., trading costs and tax inefficiencies).
For example: $10MM earning an annual gross return of 8%, would equal just over $1000MM after 30 years. However, if that investor pays just 0.5% per year in fees, that number drops to just over $87MM. 1% drops to $76MM; 1.5% to $66MM; and 2% leaves the investor with just over $57MM. So, even small amounts of fees every year add up to BIG amounts of money over the long run. The difference in costs alone is a major reason why most active investors underperform.
2. Efficient Markets & Fierce Competition
Markets are extremely efficient and are becoming more efficient every day due to technology, increased financial acumen among investors, and competition. Any arbitrage or “alpha” _opportunities that exist are quickly exploited by follow-on investors and quickly go away. While arbitrage and alpha opportunities very much exist, consistent exploitation by the same investor over the longer term is virtually impossible. Moreover, any historical outperformance by an investor is just that: historical past performance that is highly unlikely to persist into the future. Finally, there is no evidence that anyone can systematically select and hire managers that will outperform in the future. It is purely luck.
Investors constantly try to time the markets, but there is no evidence that anyone can consistently do so. The problem is that most stock returns are made on just a few trading days. For example, if you missed just the best 25 trading days from 1990-2018 on the S&P 500, your money would have been better off in U.S. 5-year notes. Moreover, simply “knowing” a recession is coming soon isn’t good enough to trade on since, to really take advantage, one would really need to know the exact day of the peak and trough of the market. Indeed, a lot of stock market gains occur right before a recession. My favorite quote on market timing comes from William Bernstein who says that “When all is said and done, there are only two kinds of investors: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third kind: those who know they don’t know, but whose livelihoods depend on appearing to know.”
Most stock market returns are from a small fraction of shares. The top 50 stocks accounted for 40% of the total market returns from 1926-2016, and five companies (Apple, ExxonMobil, Microsoft, GE, and IBM) accounted for 10% of all created shareholder wealth. In fact, over 50% of the stocks listed in America in the past 90 years were actually worse investment than treasury bills. Most gains in the S&P 500 recently (January 1, 2015 – present) have been from six companies: Facebook, Amazon, Apple, Netflix, Microsoft, and Google.
3. Behavioral Biases
The final reason most investors underperform a market is because of innate behavioral biases that we all as humans come pre-programmed with. There are far too many biases to list here, but I’ll provide a few of them here in bullet point to give some flavor:
· Hindsight Bias – Also known as the “knew-it-all-along” phenomenon or creeping determinism, refers to the common tendency for people to perceive events that have already occurred as having been more predictable than they were before the events took place. As humans, our brains are continually constructing stories and narratives to make sense of the world, piecing together complex stimuli and events to make a holistic picture that makes sense. Things, therefore, make sense in hindsight.
· Loss Aversion Bias - Refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains: It is better to not lose $5 than to find $5. Loss aversion causes investors to avoid short term losses at the expense of long-term gains (i.e., selling when the market is down 20% because you’re afraid of being 40% down instead of holding out for the long term rebound).
· Home Bias – Most investors are overexposed to their home country’s market. This is true for U.S. investors, but also most other countries. So far, this has not been a major issue for U.S. investors, but there is always a risk that the U.S. is Japan in the late 1980s. If you invested in Japan in the late 80s, you still would not have recovered.
· Sunk Cost Fallacy – Continuing a behavior or endeavor as a result of previously invested resources.
· Herding Behavior – When people do what others do instead of using their own information or making independent decisions. The cause of many a stock market bubble.
Science-Based Investing – How Should Investors Invest?
The cardinal rule of investing is that risk and return are inextricably linked. If you want high expected returns, then you need to take a lot of risk. If you want low risk, then you’re going to have low expected returns. There is no free lunch. Any arbitrage opportunities for alpha are hard to come by and, even if exploited by the investor, are very unlikely to last for long because other investors will soon follow, further exploit the arbitrage, and cause it to disappear. It is extremely unlikely for that investor to continually find alpha over and again and it’s getting harder every day. Moreover, it is impossible know whether the realized alpha was due to luck or skill. Academic research shows that disentangling investment luck from skill is impossible. So what should the investor following the scientific method do?
Be passive, do not try to find alpha. This means you should not try and pick individual stocks or time the market. The price of the stock and the market as a whole should be taken at face value for investors. While assets and markets are not always priced correctly, most investors should assume that they are. Figuring out which assets and markets are mis-priced is extremely difficult and costly. Investors should behave as if markets are perfectly efficient.
Investors following the scient should replicate the global market in the most cost-effective manner possible (i.e., index funds and ETFs) and own assets in proportion to the size of each asset within the overall market. Anything that deviates from this is a bet. Said differently, if you allocate more percentage of your capital than the market does, you are betting against the market and are an active investor, who we know has a 97% chance of underperforming the market over the long-term. Investors that want higher expected returns than replicating the global market can either concentrate their portfolio toward riskier assets or keep their asset allocation the same and apply leverage. The latter is a better option since it increases the risk and expected return of the portfolio without sacrificing diversification.
In sum, investors that want to earn consistent, positive expected returns over their lifetimes should adhere to the scientific method and invest in a passive, market-based portfolio. It does not take bets or speculate on the direction of any market, because it does not need to. No matter what happens in the global economy, the portfolio should perform well in the long run because it owns everything. There is no need to analyze, speculate, pick, or choose where to invest your capital. There is also no need to pick stocks or time the market. Being truly passive reduces fees, costs, taxes, and other expenses – the enemies of most investors. Follow the science and the rest should take care of itself.