Is There a Science to Investing?

The majority of my recent commentaries have dealt with developing a prudent process and discipline. In addition, we discussed the importance of including equities in your savings plan. We talk about the influence of the Wall Street bullies on your investments decisions. How these bullies use your emotions against you and the need for an investor coach.

Bottom of Wall Street from FDR
Bottom of Wall Street from FDR (Photo credit: SheepGuardingLlama)

It may be time to discuss how science can help you invest with confidence and peace of mind.

The Wall Street bullies need us to believe that they can predict the future and put us into the ‘right’ investments.

What these bullies do not want us to know is that prudent investing relies on science and not ‘art’.  By relying our investment decisions based on science rather than our emotions we will reduce our anxiety and improve long term results.

Two of the top academics have proven an answer to the question

“Where do returns come from?”

through extensive scientific research. The Three Factor Model was developed by Eugene Fama of the University of Chicago and Kenneth French of Yale.

If this theory along with other components were implemented by the Main Street investor there would be a revolution by the Wall Street bullies.

The first factor is the equity premium. Through extensive research of data from 1927 to 2010 there is a 7.82% premium in owning equities over risk free investments.

The second factor deals with the size or small premium, looking at this same data there is a 3.24% premium in holding small stocks in your portfolio. In other words since small stocks realize more risk than large stocks, investors require a premium to hold them.

The third factor proves that ‘value’ or distressed stocks realize a premium of 4.82% over growth stocks. Value companies are those with large

When you consider the equity premium, small premium and value premium you explain an extremely high level of confidence of understanding where the rate of return in your portfolio comes from.

Please keep in mind that this is a very brief explanation of the Three Factor Model, however it shows the advantage of including scientific and academic research when making investment decisions.

This research proves that the Wall Street bullies have been misleading investors into believing that stock picking, market timing and track record investing work.

Of course we need to understand that past performance is no indication of future results. However, given this extensive research we can confidently make our investing decisions. If we keep a long term focus to our investments we will succeed in reaching our long term financial goals.

The Three factor Model is one component is developing a scientific prudent portfolio. This combined with other academic theories give us the tools to build a secure financial future.

I believe when you understand that there is a scientific reason for making your investment decisions you can move forward with confidence. Confidence that in the long term you will succeed.

The Wall Street bullies will try to convince you that they can

  • Time the market (Get in and out at the right time)
  • Know the best time to be in small, growth or value stocks, bonds, cash, annuities………
  • Pick the stocks which will out perform

Extensive academic research proves that this cannot be done long term.

So, yes there is a science to investing, however remember all these theories are tools. Because you are human you will allow your emotions to change your direction during market down turns, as well as, strong up markets.

In most cases you will require the assistance of an investor coach. to keep your emotions in check.

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