Yariv Haim – How evidence-based investing can help younger investors

If I knew then what I know now:

The last 18 months have been something of a white-knuckle ride for many long-term investors. But for first-timers—particularly those in their twenties and thirties— the opportunity to generate large returns by leveraging extreme volatility has proven highly enticing.

Indeed, research last year found “Gen Z” and “Millennial” consumers to be 66% more likely to invest over the following 12 months than their “Baby Boomer” counterparts.

Anything that gets the younger generation interested in investing is a huge positive. The earlier one starts, the more capacity they have to recover from the inevitable setbacks. This allows them to move up the risk scale and potentially be rewarded for that over the longer term. Older investors don’t enjoy this flexibility.

But young investors still need to exercise caution when it comes to putting their hard-earned savings at risk.

New investors can fall into several costly traps when dipping their toe into the markets. Even passing the management process to an expert carries its own set of avoidable risks. Thanks to compounding, the cost of many of these setbacks is amplified over time.

As an alternative, evidence-based investing offers young investors the opportunity to maximise market returns by being invested for longer in the market while minimising fees and cutting out unnecessary risk entirely.

Bad timing and behavioural bias

A natural starting point for a novice investor is to allocate their cash to a few stocks. This can be extremely profitable—we’ve all seen the headlines telling us how much our £1,000 would be worth today if we’d invested in a hot stock at the right time—but it is also very risky.

Imagine if a twenty-something investor were to read about three stocks online and put £1,000 into each. Then, imagine that—rather than soaring—the value of one of these holdings were to fall to zero in a matter of days.

A third of the investors’ total portfolio would be wiped away almost overnight. Recovery would require a remarkable rise in the value of the remaining holdings.

One way of reducing such stock-specific risk is to buy a fund. This can offer first-timers a great way of experiencing the benefits of the stock market under expert guidance whilst spreading risk considerably.

Apart from being able to analyse the underlying stocks in detail, fund managers are also wise to the benefits of diversification– reducing portfolio risk by investing in many stocks across many sectors to ensure the performance of one does not overwhelmingly influence the overall outcome.

But there are drawbacks. A raft of research suggests that humans (including fund managers) are prone to letting their emotions guide their investment decisions rather than rational thinking alone.

Our innate fear of loss can see even the most skilled investor panic-sell underperforming investments too early, crystalising losses at the market bottom ahead of subsequent recovery. Similarly, our over-confidence can lead us to add to strongly performing holdings at the top of the market, right before the tide dramatically turns.

These behavioural biases apply to everyone. Studies overwhelmingly conclude that historical outperformance by fund managers tends not to persist across subsequent periods.

Now throw in the fact that most actively managed funds charge significant fees, eroding a considerable portion of the gains they do make…

The combination can leave first-time fund investors sitting on underwhelming returns over the long term.

Evidence-based investing

Neither of these options fully optimises the market opportunity on offer to young investors. One solution that does do so is a portfolio managed according to evidence-based principles.

Evidence-based solutions focus risk as the driver of returns. Risk tolerance is informed by the investor’s financial capacity and psychological make-up.

From here, rather than building a portfolio of stocks picked using subjective human assumptions, evidence-based investors lean on robust, peer-reviewed academic studies underpinned by decades of historical data to establish an optimum asset allocation for their particular risk profile.

So, why is evidence-based investing particularly ideal for younger investors?

Much like a mutual fund, the approach offers full diversification benefits and oversight (in this case reams of historical data) to swerve common first-time investment pitfalls.

The evidence-based investor maintains their risk allocation through systematic rebalancing across the full market cycle. This means that the human emotion, tactical allocation, and market timing that inevitably eat up portfolio returns—particularly over a very long investment horizon—are removed entirely from the equation.

Because they are about broad market access, evidence-based investment strategies typically comprise highly efficient passive vehicles like index funds and ETFs. The avoidance of individual stock selection, and associated research costs, means that these vehicles incur extremely low ongoing fees. The erosion of young investors’ returns is minimised – a benefit which compounds over time.

Baskets of stocks easily allow evidence-based investors to tilt portfolios towards a particular theme—such as sustainability, which has proved particularly popular with younger investors.

A superior approach

Investing young is a smart move, any way you look at it.

But to make the most of the “golden egg” that comes with a long investment horizon, new investors in their twenties and thirties must avoid and minimise unnecessary risks and unrewarded costs wherever they can. The impact of these is only amplified over time.

Evidence-based investing can offer those with many years in the market ahead of them the opportunity to consistently profit through diversification, cost efficiency, and the conscious avoidance of human bias.

Yariv Haim

CEO, Sparrows Capital