When it comes to investing, the debate often sounds like it’s between two opposing camps: “active” management and “passive” indexing. But this is a false choice. There is a third, more robust approach that combines the best of both worlds: evidence-based investing.
Understanding the difference is the first step to building a portfolio that truly aligns with your long-term goals.
1. Active Management: Looking for the Needle
- The Philosophy: Active management is the traditional Wall Street approach. It’s based on the belief that a smart manager can “beat the market” by finding “the needle in the haystack.”
- The Method: This involves forecasting (predicting which way the economy will go), market timing (guessing when to get in and out), and stock picking (researching companies to find undervalued gems).
- The Problem: Decades of academic data show that the vast majority of active managers fail to beat their benchmark over the long term. This strategy is not only unreliable, but it’s also expensive, with high fees and frequent trading that can increase your tax bill.
2. Passive Indexing: Buying the Haystack
- The Philosophy: Passive investing is a direct response to the failures of active management. It’s based on the belief that since it’s so hard to beat the market, you should just be the market.
- The Method: This involves buying a low-cost index fund, like one that tracks the S&P 500. You own all 500 stocks, guaranteeing you get the market’s return—no more, no less. It’s a simple, low-cost, and effective strategy.
- The Problem: While it’s a huge improvement, a simple indexing strategy can be a blunt instrument. It doesn’t allow you to thoughtfully take on more risk in pursuit of more expected return. It’s a one-size-fits-all solution.
3. Evidence-Based Investing: Owning the Right Haystacks
- The Philosophy: This is the approach we follow. It starts with the passive belief that markets are largely efficient, but then adds a crucial layer of academic rigor. Nobel Prize-winning research has identified specific, persistent characteristics (or “dimensions”) that lead to higher expected returns over time.
- The Method: Instead of just buying the whole market based on market capitalization, we build portfolios that are strategically tilted towards these dimensions of higher expected return—specifically, companies that are smaller, more value-oriented, and more profitable.
- The Difference: This isn’t active guessing. It’s a disciplined, rules-based way to structure a portfolio based on decades of evidence. It combines the low costs and diversification of passive indexing with the more strategic, return-seeking tilts of active management, all without the guesswork.
You don’t have to choose between a high-cost gamble and a generic index. An evidence-based approach is a smarter way to invest, designed to put the odds of success on your side for the long run.