Do you (1) hope investors can come out ahead by finding mispriced stocks, bonds, and other trading opportunities; and by dodging in and out of rising and falling markets?

Or do you (2) accept all investors' investment insights create relatively efficient market pricing that is too random to predict consistently?

An overwhelming body of evidence suggests investors should skip the first approach and adopt the second assumption. This has been the case since at least 1952 when Harry Markowitz published Portfolio Selection in The Journal of Finance. In their book, “In Pursuit of the Perfect Portfolio,” Professors Andrew Lo and Stephen Foerster describe:

“While it’s commonplace now to think of creating a diversified portfolio rather than investing in a collection of securities that each on their own look promising, that wasn’t always the case. It was Harry Markowitz who provided a theory and a process to the notion of diversification. He helped to create the industry of portfolio management.”

Markowitz’s work became known as Modern Portfolio Theory (MPT), academics and practitioners have been building on it ever since. His initial work and others’ subsequent findings strongly support ignoring all the near-term noise and taking a long-view approach. This involves creating a unified investment portfolio and focusing on more manageable details, such as:

• Tilting toward or away from entire asset classes to tailor your risks and expected returns
• Minimizing avoidable risks by diversifying globally
• Reducing unnecessary costs
• Controlling your own damaging behavioral biases

At first blush, nearly every investment recommendation may seem “evidence-based.” After all, few forecasters peer into actual crystal balls to make their predictions. And no market guru would admit their stock-picking track record has been no better than a dart-throwing monkey’s (even though that’s usually the case).

Instead, stock-picking and market-timing enthusiasts tend to argue their cases by turning to articulate analyses, clever charts, and convincing investment briefs. They use these props to explain the late-breaking news and recommend what you should supposedly be doing about it.

There’s nothing wrong with facts and figures. The critical difference is how we apply them as evidence-based investors. As financial author Larry Swedroe describes it:

“In investing, there is a major difference between information and knowledge. Information is a fact, data, or an opinion held by someone. Knowledge, on the other hand, is information that is of value.”

— Larry Swedroe, ETF.com

No matter how compelling a call to action may be, we discourage frequent reactions to the never-ending onslaught of information. Before acting, we must ask ourselves:

Which current information might add substantive value to our decisions by refuting or adding to the existing evidence? Or is this “new” information just more of the same old noise, already factored into our evidence-based investment strategy?

Because there is much more noise than valuable knowledge available to investors, the basic recipe for evidence-based investing begins with academic rigor. It should always be a key ingredient in separating likely fact from probable fiction:

• It requires robust data sets that are large enough, representative enough, and free from other typical data analysis flaws.
• Authors should be impartial, lacking incentives to “torture” the data to make a point.
• Other studies should be able to reproduce the same findings under different scenarios, suggesting the results are more likely to persist upon discovery.
• The data, method, and results should be published in reputable, peer-reviewed forums where informed colleagues can comment on the findings.
• Enough time must pass to make all the above possible.

After that, we also must be able to apply the results in the real world. In other words, even if a theoretical strategy is expected to enhance your returns, it must do so after considering all practical costs and portfolio-wide tradeoffs involved. For example, sometimes, one source of expected returns may offset another, even more significant, source. Occasionally, we can combine them for even stronger results; other times, it’s best to favor one over the other.

So, which factors appear to explain different outcomes among different portfolios best? What combinations of these factors are expected to create the strongest, risk-adjusted portfolios? What explains each factor’s return-generating powers, and can we expect those powers to persist?

Academic research has found several factors that point to differences in expected returns. Analytical scholars have thoroughly documented the differences in expected returns generated by the various factors in markets around the world and across different time periods.

Based on the academic answers to the practical questions posed above, we typically mix and match the following factors in our evidence-based portfolios, varying specific exposures based on each investor’s personal goals and risk tolerances:

• The Market: Stocks (equities) vs. bonds (fixed income)
• Company Size: Small vs. large company stocks
• Relative Price: Value vs. growth company stocks
• Profitability: High-profit vs. low-profit company stocks
• Term: Long-term vs. short-term bonds (based on maturity date)
• Credit: “Safer” vs. “riskier” bonds (based on credit quality)

If higher inflation does materialize, will it arrive sooner or later? Will it be moderate or severe? Brief or prolonged? Forecasts vary widely because we often forget the academic evidence that informs us: Even excellent explanatory models rarely serve as effective predictive models.

For example, scientists can readily explain why earthquakes occur, but our ability to forecast times, locations, and severities is shaky at best. The same can be said for inflation. We can explain its intricacies, but accurate predictions remain as elusive as ever. There are simply too many variables: COVID-19, climate change, political action, the Federal Reserve, other central banks, consumer banks/lenders, consumers/borrowers, employers/producers, employees, investors (“the market”), sectors (such as real estate, commodities, and gold), the U.S. dollar, global currency, cryptocurrency, financial economists, the media, the world, time … and YOU.

Each of these could throw off any predictions about the time, degree, and extent of future inflation. Besides, as an investor, you only have control over the last two: You and your time in the market. What will you do with your time?

It makes sense: Some investments seem to shine when inflation is on the rise. Others deliver their best results at other times. Because we never know precisely when inflation might rise or fall, we believe an investor’s best course is to diversify into and across various investments that tend to respond differently under different economic conditions.

For example, until earlier this year, value stocks had been underperforming growth stocks for quite a while. You may have been tempted to give up on them during their decade-plus lull (during which inflation remained relatively low). And yet, when inflation is high or rising, value stocks have tended to outperform growth, as has been the case year-to-date.

Another example is Treasury Inflation-Protected Securities (TIPS) versus “regular” Treasury bonds. Neither is ideal across all conditions. But if you hold some of both, they can complement each other over time and across various inflationary rates.

In short, if you’ve not yet done so, it’s time to define your financial goals and build your personalized, globally diversified portfolio to complement them. If you’ve already completed these steps, you should be positioned as best you can to manage higher inflation over time, which means your best next step is most likely to stay put. This brings us to our next point.

Provided time is on your side; the stock market is your greatest ally against inflation.

Over time, global stock market returns have dramatically outpaced inflation. For example, as reported by Dimensional Fund Advisors, $1 invested in the S&P 500 Index from 1926–2017 would have grown to $533 worth of purchasing power by the end of 2017, after adjusting for inflation. Had that same dollar been held in “safe” one-month Treasury bills over the same period, it would have grown to an inflation-adjusted $1.51.

That T-bill growth is more than nothing and welcome relief during bear markets. That’s one reason we advocate for keeping an appropriate mix between wealth-accumulating and wealth-preserving investments. But what’s “appropriate”? It depends on your personal financial goals. The point is, as long as you have enough time to let your stock allocations ride through the downturns, you can expect them to remain well ahead of inflation simply by being in the market.

It’s important to add; no fancy market-timing moves are required or desired when participating in the stock market. Moving holdings in and out at seemingly opportune times is more likely to detract from the vital, inflation-busting role stocks play in your portfolio. In the words of Nobel Laureate Eugene Fama: “The nature of the stock market is you get a lot of the return in very short periods of time. So, you basically don’t want to be out for short periods of time, where you may actually be missing a good part of the return.”

So far, so good. But not all your wealth is for spending in the far-off future. What if you depend on your portfolio to supply a reliable income stream here and now? If you’re retired (or you have other upcoming spending needs such as college costs), eventual expected returns offer little comfort when current inflation is eating into today’s spending needs.

Again, you can’t control inflation, but you can manage your own best interests in the face of it.

Along with a globally diversified investment portfolio, you’ll want a solid strategy for investing for and spending in retirement. For example:

• Asset Location: Among your taxable and tax-favored accounts, where will you locate your stocks, bonds, and other assets for tax-efficiently accumulating and spending your wealth?
• Spending: How much can you safely withdraw from your investment portfolio to supplement your other income sources (such as Social Security)?
• Withdrawal Strategies: Which accounts will you tap first and then next?

Especially when inflation is on the rise, it’s worth revisiting your existing investment and withdrawal strategies. What are the odds your current portfolio won’t deliver as hoped for? We typically use odds-based “Monte Carlo” simulations to ask this critical question and guide any sensible adjustments the answers may warrant.

What if inflation is taking too big a bite? A common misstep is to abandon your carefully structured investments in pursuit of short-cuts. For example, it may be tempting to unload high-quality bonds and pile into gold, dividend stocks, or other ways to seek spendable income. Unfortunately, we believe such substitutes detract from effective retirement planning. The goal is to optimize expected returns and manage unnecessary risks in pursuit of a dependable outcome. As such, we suggest avoiding dubious detours along the way.

What can you do instead? In “Your Complete Guide to a Successful and Secure Retirement,” authors Larry Swedroe and Kevin Grogan describe how to prepare an honest “Plan B.” If a worst-case scenario is realized, you’re then better positioned to make any tough decisions required to recover your footing. The authors explain:

“Plan B should list the actions to be taken if financial assets drop below a predetermined level. Those actions might include remaining in, or returning to, the workforce, reducing current spending, reducing the financial goal, and selling a home or moving to a location with a lower cost of living.”

These sorts of belt-tightening choices are never fun. But you should prefer them over chasing unsubstantiated sources of return that could dig your risk hole even deeper.

Inflation is the rate at which a currency loses its purchasing power as prices increase over time. So, say a cup of coffee cost $1.00 twenty years ago. If the average annual inflation rate had been 2% between then and now, that same pour would now cost you $1.49. Various goods, services, and sectors often experience different inflation rates at separate times, but general inflation is usually calculated based on the Consumer Price Index (CPI) or a similar broad pricing index.

Recent headlines have been reporting a noticeable uptick in inflation. Superlatives like “best” and “worst” grab the most attention, so outlets have been abuzz with reports of how a 5% May consumer pricing surge was “the biggest 12-month inflation spike since 2008.”

Before you read too much into these recently rising numbers, it’s worth remembering their context. We’re comparing May 2021 to May 2020, when we were still deep into what The Wall Street Journal called a “screwy” pandemic economy. The WSJ explained, “If a company takes a hit in one year and then gets back to normal the next, it can look like its profits are soaring when in fact they are just getting back on track.”

Zooming out even further, the Federal Reserve’s 10 Year Break-Even Inflation Rate is one common estimate of the market’s expected average annual inflation rate for the next ten years. As of mid-June, that rate stood at 2.3%. That’s up from the lower 1.2% rate expectation from mid-June 2020, but it’s still not eye-popping.

This leads to another crucial point: Not all inflation is bad. A bit of inflation goes hand in hand with economic growth and reasonable interest rates for lenders and borrowers alike. A 2% annual inflation rate is typically considered a desirable norm for greasing the wheels of commerce without destroying the working relationship between currencies and costs.

A second coming? That last one shows the extent of optimism found in the current narrative diffusing through the global financial markets.

Now, think back to April 2020. A year ago, fear was tempting many investors to pile into safe-harbor holdings, even as most markets staged robust and surprising recoveries.

This year, we’re seeing many of those same investors chasing all kinds of hot holdings, as they now embrace an absence of fear. Consider these quarter-end headlines:

• “Family Offices Like Archegos Take Big Risks Like Hedge Funds” — The Wall Street Journal
• “Robinhood Trader’s Battle Cry: ‘It’s All Just a Game to Me’” — Jason Zweig, The Intelligent Investor
• “Institutional investors putting risk back on the table” — Pensions & Investments

In its quarter-end recap, The Wall Street Journal summarized similar sentiments as follows:

“If there is a unifying theme to all this, it is that investors big and small showed no fear of risk-taking to start 2021. In fact, they embraced it.”

Sometimes, an extra shot of bravery is just what the doctor ordered. “No fear,” you might tell yourself as you enter your first marathon, launch a new business, or hug your college-bound child farewell. In investing, however, no fear can be as damaging as an excess dose of fear.

There are numerous proverbial sayings in every culture along the lines of “all things in moderation.” While taking things in moderation is often true in life, it’s true in investing too.

Moderation is vital to keep in mind given the investment environment we encounter today. The efficient market hypothesis proposes that asset prices are set by rational investors, whose primary concerns are systematic risk and expected returns. However, asset prices may now, more than normal, be fueled by investors’ desire to be part of a social movement, hopes to strike it rich, or plain old envy. While there are many reasons to own a stock, it helps to keep an accurate assessment of the potential risks and rewards involved in any given approach.

With activity in many industries sharply curtailed in an effort to reduce the chances of spreading the coronavirus, some economists say a recession is inevitable if one hasn’t already begun.¹ From a markets perspective, we have already experienced a drop in stocks, as prices have likely incorporated the growing chance of recession. Investors may be tempted to abandon equities and go to cash because of perceptions of recessions and their impact. But across the two years that follow a recession’s onset, equities have a history of positive performance.

Data covering the past century’s 15 US recessions show that investors tended to be rewarded for sticking with stocks. Exhibit 1 shows that in 11 of the 15 instances, or 73% of the time, returns on stocks were positive two years after a recession began. The annualized market return for the two years following a recession’s start averaged 7.8%.