Use Your Skills for Evidence-based Investing

Physician's Money Digest, July 2006, Volume 13, Issue 7

In both medicine and investing youmust heed the scientific evidence,but you must also recognize thatthe science will often not provideyou a definitive answer; you willhave to rely on your gut feelings to someextent. But to develop a gut whose feelingsyou can trust, you need to absorb asubstantial amount of the scientific researchresults and accumulate a greatdeal of real-life experience. Physiciansare trained to rely heavily on evidence,yet when it comes to investing, physiciansrarely look for the scientific evidencebefore putting down a goodchunk of their hard-earned money on arecommendation or some investmentidea that casually seems attractive.

Scientific Approach

In part, physicians do not practiceevidence-based investing because theydo not realize that there is a lot of scientificevidence available to examine andthat the evidence is inaccessible to them.In reality we have nearly 40 years ofhigh-quality scientific research results ininvesting that demonstrate almost unequivocallywhich investment approachesare likely to work in thefuture, and more important, which arenot likely to work and may even be dangerous.Yet most investors who followWall Street's lead and recommendationsinvariably take the dangerous road.

For example, the evidence clearlyshows that the so-called growth stocks,which may be better described as glamourstocks, perform much worse thanvalue stocks in the long run. The reasonis that the glamour stocks tend to be significantlyoverpriced because of thehigh expectations about them. Even aDell or Microsoft cannot live up to suchhigh expectations forever and ultimatelyfalter. What's more, Dell andMicrosoft would have been greatinvestments if it were possible to predictin their early years that they would bethe companies that would survive andthrive from among the other dozens ofcompanies that appeared equally glamorousback then. Unfortunately, thisbecomes clear only in retrospect.

Value stocks do much better in thelong run mostly because the expectationsabout them are so low they sell atreasonable prices. If they can exceed thelow expectations, which they often do,they can provide excellent returns totheir shareholders. There are manyother similar research results that youwill rarely hear from Wall Street,because Wall Street is mostly busy promotinggrowth stocks like Google thatare priced for perfection and more.

Sources of Information

The

Future for Investors

What

Works on Wall Street

On the issue of the accessibility of theevidence, it is true that the originalresearch papers in the peer-reviewedjournals are not accessible to the generalpublic. But there are several booksthat present them in language that anyphysician can follow with somepatience and perseverance. Two suchbooks I can highly recommend are (Crown Business;2005) by Professor Jeremy Siegel of theWharton Business School and (McGraw-Hill;2005) by James O'Shaughnessy. I haveto caution you that even though thesebooks mostly avoid technical languageand higher mathematics, they are notexactly beach reading for most people.

The evidence they present is eyeopening. For example, both writersdemonstrate that there are simpleinvestment strategies that are likely toearn significantly higher returns thanthe broad-based market indexes suchas the S&P 500 or the Dow JonesWilshire 5000 Total Market indexover the long run. You will not hearmuch about these strategies from WallStreet, because they lack the glamourand mystique that can justify high fees.But if you or your investment advisordo not study and deploy these evidence-based investment strategies, youwill most likely miss out on some greatreturns that can make the differencebetween a comfortable retirement andan anxiety-ridden retirement.

Chandan Sengupta, author of The Only

Proven Road to Investment Success (John

Wiley; 2001) and Financial Modeling Using

Excel and VBA (John Wiley; 2004), currently

teaches finance at the Fordham University

Graduate School of Business and consults with individuals

on financial planning and investment management. He welcomes

questions or comments at chandansen@aol.com.