Throughout the COVID-19 crisis, we have been told to trust in the scientists’ data that underpins the decisions being made by governments around the world. But can the same approach be applied to investing? Rebecca Cretney and Simon Prescott answered our questions as to why they believe there is a parallel between scientists’ approach to patient care and how investors build portfolios.

How did your conversation about a potential parallel begin?

Simon: It began due to a Forbes article I read about a book called the One Page Financial Plan, by a US-based adviser called Carl Richards. In it, he details that he was discussing investments with a friend and medical practitioner who stated: “If I practiced medicine the way I invest, I would have killed half my patients.” It’s a quote Richards liked a lot and now many more do too – including me.

Essentially, the analogy sets out that, as a scientist, Richards’ friend would study peer-reviewed studies to gain confidence that he was making the right choice about a patient’s treatment, ahead of prescribing anything. The same physician, however, flagged that he failed to follow that logic when investing. Instead, he’d still seek out recommendations from friends, read the newspapers and make a decision based on a ‘gut feeling’ as to whether to buy or sell. His approach to investing didn’t involve doing any research, despite his professional reliance on it. You could argue his approach to investing was the medical equivalent of self-medicating after a couple of minutes on a search engine to determine the cause of an ailment. 

Rebecca: And this chimed with me due to a recent article I had read in the Financial Times (FT) that argued that “most” portfolio profits result from the outperformance of “a tiny number of superstar companies” that should never be sold – advice which was predicated on a series of examples that highlighted the additional gains investors would have made if they had followed the ‘sage’ advice of not selling holdings too soon. The argument had been based on a research paper that had been published (and republished with updated data), but which was subsequently condemned by peers, not least as the paper had admitted – albeit only in a footnote – that its theory was flawed if your investment portfolio was well diversified.

So it’s not just research, but research that has been scrutinised that is important…

Rebecca: With some much information available, it’s easy to find a piece of research that confirms your point of view. Called confirmation bias, it sets out that investors pay attention to the evidence that proves their point to the extent that they ignore any research that doesn’t validate their theory. In the case of the FT article, readers were drawn to the simple conclusion that “the upside of not selling is nearly unlimited” and were provided with reasons to believe. However, a more experienced investor will be able to cite lots of examples where that hasn’t happened. Ask anyone that invested in stocks such as Blackberry, Eastman Kodak, or any of the oil companies, and ignored the research providing the reasons to sell. And you only have to look at the leading stocks in today’s FTSE 100 or S&P 500 versus 20 years ago to see this is often the case.

There will, in truth, always be examples of investments that were sold, typically to realise (substantial) profits, but that continued to climb higher and post further gains over the following months, or sometimes even years. The only way of knowing though which stocks you shouldn’t have sold is through hindsight. As such, profit taking is always a sensible answer if you have seen some stellar returns and have concerns over the stock’s future.

Simon: This has been proven time and time again as the value of investments falls, as well as increases, given the economic cycle changes, existing technology is replaced by new advances and – just like anything else – some stock selections are based on fashion. In the last five years, for example, value investing has struggled with many turning their back on the approach, only to see value stocks outperform in the first three months of 2021 as the investment style become acceptable again.

What other theories has research debunked?

Rebecca: Another approach to investing that research shows to be flawed is that stocks should be only held for a very short period before being flipped. While there is significant research explaining why, it’s probably easier to illustrate the point by citing Warren Buffet, who stated: “If you aren’t thinking about owning a stock for ten years, don’t even think about owning it for ten minutes.”

This is because picking the low and high points of a stock’s value is notoriously difficult, as our colleague James explained in this article. Even if you were satisfied buying ’close’ to the bottom and/or selling ’almost’ at the top, it’s actually still difficult to earn a living over a short timeframe, let alone a longer one. This is because it would see you investing too much in too few stocks – and the benefits of diversification have been proven in research since 1952. It would also take you a considerable amount of time to pick more than a handful of stocks – even without any research. And a lot of any profit would be spent on trading fees.

Simon: Another piece of research we often highlight as flawed is that people should invest in stocks that are familiar to them, which, incidentally, often employs another of Warren Buffet’s famous quotes as part of its evidence. It argues that investors should stick to buying simple businesses that they understand. Again, examples are used, such as Nortel and Enron, to deter investors from seeking out the shares of companies with complex product lines. However, the issue here is that what is simple to an investor is often very familiar and this, in turn, typically leads to a home bias in his/her investment portfolio. Generally, people invest significantly more in their home market than its share of global market capitalisation justifies. And while there is the argument that this protects against currency risk, there are some very efficient tools that can be used to mitigate this risk. In addition, some currency diversification might be advisable if your income, property, business interests and other assets are already denominated in one local currency.

So what research do you back?

Simon: There isn’t one sole piece of research that underpins every single investment decision we, as a firm, make. Instead, it’s a combination of experience (based on real time knowledge of market movements), research from multiple third-party sources, as well as our own analysis. And, as a professional wealth manager, we have access to significant levels of all of these types of information to provide well balanced advice to all of our clients.

Rebecca: To close the loop, it’s worth highlighting that Richards’ scientist would quickly realise that doing research to underpin his investment decisions is never going to be a valuable use of his time. After all, many of the reasons he has access to the right medical research are due to his job. And the same is true of investing. So, perhaps, the only piece of research he really needed to do was to understand which professional wealth manager to select in order to tailor a portfolio designed to meet his goals and aspirations. After all, medical treatment is tailored to the patient as is investment advice to individuals. This would ensure that his investments stood the same chance of a successful outcome as his patients expected.