This quackery is still alive and well in the modern financial world.

The vast majority still believe to this day that successful investing is about knowing the future in advance. Today’s wizards – stockbrokers, fund managers, and most financial planners – demand lucrative supplication, however, if their star gazing proves wrong, the Economic Gods must be invoking their wrath for the misdeeds of the great unwashed who live in Wall St.

Whereas there are no known scientific studies measuring the success rate of forecasts from the wizards of antiquity, there are plenty measuring the wizards of today. The verdict? They stink.

Yep, it’s true. On average they’re wrong more often than they’re right. Reek, reek, reek. This chart is a typical finding – of nearly 300 wizards, more than three-quarters of them underperformed a low cost market fund.

Source: Morningstar, January 2002: all US large cap funds with at least 15 years of data.

Whereas the average Joe in the street still believes that a crystal ball session is what’s required to win at the investment game, there is academic research showing this just ain’t so. It’s not new – some of this research is nearly 50 years old now. Nobel Prizes have been handed out for these studies and yet they remain the best kept secrets in the investment world.

The truth is that investment advice is not a forecast nor is it some sort of prediction about the future. Successful investing requires an evidence-based approach. And the evidence says this:

1. Markets work.
2. Risk and return are related.
3. Diversification is essential.
4. Portfolio structure determines portfolio performance.

1. Markets work The laws of supply and demand drive markets, and markets factor new information quickly into investment prices. They might not be perfect – neither is the internal combustion engine. But it works; put it to good use or you can walk.

2. Risk and return are related The marketing teams of the more entrepreneurial fund managers, posing as Economic Scientists, claim to have done the investment equivalent of splitting the atom: of separating risk and return. “Here at McFarley Bank you can now have a long term growth investment with a capital guarantee.” Thppppt! Risk and return are opposite ends of the same stick. Balance them, don’t balance them. Either way, there is no free lunch.

3. Diversification is essential

Sure, you don’t get rewards without taking risks, but not all risks bear rewards. Capture the risks that generate statistically likely returns and avoid risks that don’t. Taking risks that fail to reliably generate returns is to take a risk that is not worth taking, and that’s not investing, it’s gambling. Avoidable risks include holding too few investments, which is basically taking a punt that your chosen ‘golden child’ will outperform the averages. They ain’t called averages for nothing. Just because Tiger Woods exists and you can swing a club doesn’t mean you can make a living playing professional golf.

4. Structure determines performance

Most of the performance of your portfolio of investments is determined by its structure, it’s ‘asset allocation’. The evidence says growth-style investments (property and shares) have higher expected returns over the long term than income-style investments (cash and fixed interest) ...

4.1 Growth investments: size and style matter

Within the growth investment arena, you may well have a fondness for property, you may prefer ‘blue chip’ shares, you may keenly follow the resources sector. Regardless of your personal passions, fifty years of financial science has determined that only two factors matter – ‘size’ (small company shares have higher expected returns than large ones), and ‘price’ (lower-priced ‘value’ shares have higher expected returns than higher-priced ‘growth’ shares). How you use these two dimensions to slice your portfolio pie will have a very large bearing on how much risk you take and how much return you can expect.

Source: Developed markets value and growth index data provided by Fama/French. S&P data is provided by Standard & Poor's Index Services Group. US Small Cap Index provided by the Center for Research in Security Prices (CRSP), University of Chicago.

4.2 Income investments: maturity and quality matter

Within the income investment arena, the two dimensions of risk and return are governed by ‘maturity’ (longer-term instruments are riskier than shorter-term ones) and ‘quality’ (lower credit quality instruments are more likely to default and are therefore more risky than higher credit quality).

How you profit from this knowledge

Are you investing or gambling? The money you have to invest – treat it like an investment rather than a punt. Don’t ‘back a winner’ with your capital; turn it instead into a portfolio of investments and diversify your portfolio around the risk factors that research shows offer a reliable reward. This offers the highest likelihood of expected returns with quantifiably manageable risk, at the lowest cost.

Then turn off the talking heads on the finance channel and go to the beach – chances are you’re going to outperform them by miles.

---