Empirical Papers


This series includes all papers, recaps, and newsletters published by Empirical.

Empirical’s 10 Steps to Investment Success

Successful investing requires an informed and well-developed strategy based on empirical evidence coupled with extensive experience and knowledge of financial markets.  There are several well-established and widely accepted tenets of investing that allow an investor to maximize expected future returns.  The role of a financial advisor is to assist investors with learning and following these proven methods.  This means more than just sending you an occasional account balance, or only being in contact when there are problems.  The relationship between a client and their financial advisor should be a collaborative process through which the advisor learns about the individual financial needs of the client while using their expertise to develop an optimal portfolio for the client’s particular situation.  With this in mind, we will use this newsletter to outline our investment philosophy.  We believe that by following these steps, investors are likely to avoid the pitfalls and chronic underperformance experienced by many individual investors and institutions alike.

1. Develop an investment strategy

The first thing any investor should do before committing any money to financial markets is develop an explicit investment strategy.  This means establishing investment goals and making a plan to achieve those goals.  Key factors include your time horizon, willingness and ability to take risk, and personal financial situation.  For example, an individual who intends to work for the next 30 years should have a very different investment strategy from someone who has just retired and anticipates the need to make withdrawals from their portfolio in the very near future.  A client should speak with their financial advisor when creating an investment strategy, as the advisor will have detailed knowledge of the many hazards that can be avoided when creating a long-term financial plan.

The individual investor should act consistently as an investor and not as a speculator.

- Benjamin Graham

2. Make investment decisions based on evidence-based research

Today’s investors are being inundated with investment “advice” nearly everywhere they turn.  It is difficult to browse the internet or read a newspaper without seeing an advertisement for the latest hot stock or investment tip.  Not only is this barrage of information overwhelming, it is generally biased and/or unfounded.  It is critical to keep in mind that people like CNBC’s Jim Cramer or the editors of Money Magazine have nothing to lose from you following their advice and, more likely, something to gain1  As Steve Forbes once said, “You make more money selling advice than following it.  It’s one of the things we count on in the magazine business – along with the short-term memory of our readers.”

Another thing to keep in mind when considering advice provided in financial media is that the person offering the advice has no knowledge of your personal financial situation, thus making them unqualified to reasonably provide you with investment strategy advice.  Generic investment advice may or may not be applicable to the particular circumstances of any given investor, and following advice not tailored to your own situation can be detrimental to your investment results.  In addition, many media personalities lack the relevant credentials that certify their knowledge of financial planning, or extensive experience in that field.  Without accompanying advice on a comprehensive financial plan, investment advice in isolation may not be appropriate.

So, if the majority of mainstream financial advice is flawed, what should an investor do?  One solution is to make sure that any investment strategies are based on evidence-based research.  This requires sifting through academic and practitioner research to determine the best possible investment methods, and verifying these findings whenever possible.  Before making any investment, an investor should conduct extensive analysis of the securities they are considering, both on an individual level and as part of an investment portfolio.  Making investments based on untested and unsubstantiated advice is like gambling; it might be exciting for the investor at the time, but it is not a good long-term strategy.

3. Diversify your portfolio

Diversification is often referred to as the “only free lunch” in investing.  By investing in assets that are not perfectly correlated (i.e., do not move exactly together through time) an investor may be able to achieve a less volatile portfolio than would be expected by the average volatility of each asset.  An example will clarify this point.  Figure 1 (below) shows the annual returns from September 2000 of two distinct asset classes: U.S. high yield municipal bonds and emerging market sovereign debt2 Along with these individual asset returns, the figure below shows the performance of an equally weighted portfolio of these two assets.

Figure 1: 
The Benefits of Diversification—9/2000-9/2012

The Benefits of Diversification—9/2000-9/2012

Source: Emerging Market Sovereign Debt (Morgan Stanley Emerging Markets Domestic Debt Fund), U.S. High Yield Municipal Bonds (Nuveen High Yield Municipal Bond Fund). See full disclosure at the end of this letter.

The key takeaway from this example is that the diversified portfolio approach will reduce the instability of the investment.  This newly created portfolio is less volatile than either of the individual series.  This is a powerful result; by adding together uncorrelated assets, the portfolio becomes less volatile.  This insight is at the center of Modern Portfolio Theory, the idea that won Harry Markowitz a Nobel Prize in Economics in 1990.

Empirical portfolios emphasize exposure to multiple asset classes, with over 13,000 individual stocks in our full Targeted Premium equity models.  Along with equity exposure, the Targeted Premium models also include exposure to alternative asset classes such as real estate and commodities.  Similarly, our Targeted Credit fixed income models have exposure to various levels of credit and varying maturities.  It is essential to constantly investigate new assets and investments and continue to expand your portfolio as appropriate asset classes appear.

Diversification can protect a portfolio from losses due to a bad outcome in one particular company, or even in a particular asset class.  However, it will not eliminate risk entirely.  Many financial commentators made the claim after the recent Financial Crisis that diversification had failed because even well-diversified portfolios suffered losses, but this assertion misses the point.  Diversified portfolios in many cases lose far less than more concentrated portfolios or individual assets (e.g., individual stocks like Lehman Brothers that became essentially worthless during the crisis), and they also tended to recover more quickly as financial markets improved. A highly diversified portfolio is a must for any investor.

4. Control your risk exposure

Diversification is not the only key component of portfolio risk management.  Even a highly diversified portfolio of risky assets will be subject to high levels of risk.  When designing a portfolio, two imperative considerations are your ability and your willingness to take risk.  These may sound similar, but they are not necessarily related, and could, in fact, differ greatly for a particular investor.

Willingness to take risk is a straightforward concept.  Some investors cannot stomach a volatile portfolio, while others are willing to tolerate large amounts of price movement if it means high expected returns.  An investor’s willingness to take risk is really a matter of personal preference, and should be determined before creating an investment portfolio.  If you are unsure of your risk preferences, an advisor can help you to determine them through a series of questions and scenarios.

Ability to take risk depends on the financial situation of the investor, as well as their time horizon.  For example, someone with a high salary who does not plan to retire for 20 or more years has the ability to take a large amount of risk, whereas a person who has recently retired and needs to begin withdrawing money from their portfolio has a much higher need for price stability, reducing their ability to take risk.  Much like risk preferences, ability to take risk should be determined with your financial advisor, so your investments can be tailored accordingly.

5. “Beat the market” by outsmarting the market

The idea of outperforming the market is one of the most vigorously debated topics in finance today, among both academics and industry professionals.  Every active3 fund manager has a story for why their fund will gain superior risk-adjusted returns relative to a particular market index.  However, financial markets are not Lake Wobegon, and it is not possible for everyone to be above average.  Exhaustive amounts of research have been conducted on this subject4 and the nearly universal consensus is that active funds do not outperform indexes on average, and actually tend to underperform due to their high costs and frequent portfolio turnover.  Further, the managers who do outperform in any given period are no more likely on average to continue to beat the market in the future.  This is not to say that it is impossible for a fund manager to consistently outperform, but that the odds of selecting one of these managers prior to their period of outperformance is extremely low.  This randomness of performance is why the prospectus of every fund will include the statement “Past performance is not a guarantee of future results.”

Even though this evidence is widely available, many individual investors still believe that they can outperform the market.  Many funds are subject to regulations that might restrict their ability to trade in an optimal manner, or perhaps the sheer size of a fund may make it difficult to act quickly enough to stay ahead of the market.  Would an individual investor trading only for their own account be able to outperform?  Two professors of finance at UC Davis5 were able to obtain trading data from a large broker, and conducted multiple studies of individual investor performance.  They found that active individual investors significantly underperform the market on average, particularly with the advent of internet trading.  Interestingly enough, after these results were published, U.S. brokerage firms have been extremely reluctant to release any more data, though similar studies in other countries have confirmed these findings6.  Though an individual may have more freedom and a more manageable portfolio than a fund company, they are extremely unlikely to have a comparable investment infrastructure, particularly with respect to research and execution.  Fund managers are generally well-educated, experienced and intelligent people. If they are unable to consistently beat the market with their vast knowledge and resources, the odds are heavily against the individual investor being able to do so either.

This does not mean that investors should simply create a portfolio and leave it forever.  It is prudent to continuously research new investment strategies as well as to track the performance of fund managers.  If a particular method of investing or manager can be empirically shown to outperform on a consistent basis, we will incorporate this into our portfolios. However, until that point we will continue to stick with the strategy that has been proven to be most effective; a low-cost, well-diversified approach.  For an individual investor, the best way to “beat the market” is to outperform the majority of other investors.  This may be accomplished by avoiding high-cost strategies that are not empirically proven to beat their benchmarks.  The Empirical Targeted Premium and Targeted Credit portfolios focus on finding the most cost-effective ways to receive market returns while minimizing risk, and these strategies have outperformed similar models that try to stay ahead of a mostly efficient market.

6. Stick with proven techniques

As mentioned above, evidence shows that it is nearly impossible for an investor to beat the market.  To understand this statement, it is important to understand what is meant by “the market,” and what that means in the context of an investment portfolio.  Many people use well-known and widely publicized indexes like the Dow Jones Industrial Average or the S&P 500 as a proxy for the market.  This is fine, as long as you understand these indexes represent only a segment of the market, which, in this case, happens to be large cap U.S. stocks.  A common metric used in defining market segments is the “style box” popularized by Morningstar (see Figure 2 below).

Figure 2: Equity Style Box

Equity Style Box

Using this method, stocks are separated by equity style (i.e. value versus growth) and market capitalization (i.e. large versus small).  For example, the S&P 500 Index would fall in the top middle (Large-cap Blend) section of the style box.

This distinction is important, as performance differs across various sizes and styles.  Professors Eugene Fama and Kenneth French famously documented the “size and value effects,” showing that small cap stocks tend to outperform large cap stocks in the long run, and that value stocks (stocks with a low price-to-earnings (P/E) ratio) outperform growth stocks (those with high P/E ratios) over long horizons as well.  These effects hold across time and around the world.  In addition to size and value premiums, emerging market equities have tended to generate superior returns over equities of developed countries.  Figure 3 (below) shows these effects over the previous 85 years (or as long as the markets in question have existed).

Figure 3: Size And Value Effects Are Strong Around The World

Size And Value Effects Are Strong Around The World

Source: Data provided by Dimensional Fund Advisors. See full disclosure at the end of this letter

As can be seen from Figure 3, these effects are both consistent and significant.  With this in mind, Empirical portfolios have value, small cap, and emerging market tilts in order to capture these premiums.  However, it is important to note that while these asset classes have outperformed over long periods of time, they will not do so every day, or even every year.  For example, U.S. growth stocks significantly outgained value stocks in the late 1990’s during the technology boom.  This disparity was short-lived, and quickly corrected itself after the dot-com bubble ended in 2000, when many investors suffered large losses in their portfolios because they shifted from value into growth based only on recent performance.  Even the best investing methods will not work 100% of the time, and it is important that the investor always remembers that investing is a long-term process.

7. Focus on tax efficiency

An aspect of investing that is often overlooked is the tax consequence of a particular investing strategy.  Investors are subject to different tax rules depending on how their portfolios are managed.  For example, if an investor buys a stock and sells it within a year of the original purchase, any gain on the stock is considered ordinary income, and taxed as such.  However, any gain on an investment asset that is held for over a year is taxed as capital gains, resulting in a much smaller tax burden for the majority of investors.  This tax differential is another reason that Empirical favors a low turnover investment strategy; high trading volume can generate unnecessary tax costs that will eat away at positive returns.  Along with portfolio stability, Empirical has two important strategies that help investors minimize their tax burden: Tax-loss harvesting and asset placement.

Tax-Loss Harvesting:

Tax-loss harvesting describes the process of actively capturing capital losses for the investor, allowing them to offset some of their investment gains without fundamentally changing the makeup of their portfolio.  Tax-loss harvesting is a service that we provide our clients through the use of “substitute” funds.  For example, suppose a portfolio contained a U.S. large cap index fund that tracked the S&P 500, and this fund suffered a 10% loss.  To take advantage of this capital loss, our portfolio manager would sell the fund at a loss, and instantly invest that money in a similar fund (in this case, another S&P 500 index fund) to keep the portfolio relatively unchanged.  This way, the investor receives the tax offset without losing their exposure to this asset class.  As that asset class recovers, so will the value of that investment, but a “loss” has been captured for tax purposes.  With this in mind, every fund in an Empirical portfolio has at least one (and generally several) “substitute” funds that can be used for tax-loss harvesting.

Asset Placement:

In terms of taxation, not all retirement accounts are created equal.  Some accounts are tax-exempt (Roth IRAs), others are tax-deferred (traditional IRAs) and finally, non-IRA accounts have no special tax benefits.  The tax status of an account has important implications for an investor’s overall financial situation.  To address this issue, Empirical uses a technique called Asset Placement, where an investor’s assets are allocated in the manner that is most tax efficient.  By taking these basic precautions, the tax burden of an investor can be greatly reduced.  For a closer look at tax-loss harvesting, asset placement, and other methods of tax management, please see our white paper7 on the subject.

8. Avoid unnecessary trading costs

A key reason why it is difficult for an active trader to outperform the market is the trading costs inherent in actively managed strategies, which tend to involve high amounts of portfolio turnover.  These costs include broker commissions, the difference in the bid-ask spread (i.e. the difference in the price that an asset can be bought or sold at), or slippage (any adverse movement in prices after the decision to buy or sell a security has been made, but before the trade has been executed).  The more often a strategy trades, the more these costs will eat away at any possible gains.  Even under passive strategies, trading costs can be harmful to returns.

Successful investors are conscientious of the costs involved with trading, and do their best to avoid unnecessarily creating them.  Our strategy involves using minimum trade sizes, meaning we will not generally trade a position unless the trading costs are less than a certain percentage of the nominal trade.  In addition, we are able to trade certain funds without incurring trade costs, allowing the use of “sweep funds,” meaning that money can be invested in certain segments of the market without cost, so that your portfolio can stay fully invested at all times without undue expense.

9. Periodically review your investment needs and change your portfolio accordingly

The underlying theme of this newsletter is creating an optimal portfolio.  There is no universal answer to this; optimality depends on the needs and preferences of the investor.  An investor’s situation is rarely static.  Significant life events, such as the birth of a child, a purchase of a new house, a child going to college, a breadwinner losing/changing jobs or approaching retirement, could necessitate strategic portfolio adjustments.  The portfolio that is optimal for you when you begin investing may not be right for you in the future.  In some cases, the appropriate portfolio may be designed to update on an annual basis to match the changing needs of the investor8. Periodically reviewing your personal situation with your advisor is a prudent way to ensure that your portfolio design remains appropriate and on target.

It is important to clarify that this step is not recommending that an investor change their portfolio based on things like market movement or their feelings on the current state of the economy.  This type of market timing behavior rarely works well, and will likely cause your portfolio to underperform because you are reacting to things that have already happened, and thus have already been priced into the market.  You should only be adjusting your portfolio as a result of changes in your own financial situation, not as a reaction to market conditions.

Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.

- Paul Samuelson

10. Be patient and persistent: Stick to your strategy regardless of what the market is doing at the time

If you have followed steps one through nine, at this point you have a well-diversified portfolio built on solid evidence-based fundamentals.  Now it is time to let your investment strategy work.  This means committing to leave your investments alone regardless of daily market movement.  It means considering your portfolio without emotion.  As discussed above, it is important to periodically consider your investments in the context of your personal financial situation, but not because of how you feel about financial markets.  This sounds easy, but can be the most difficult part of investing.

Because finance is a multi-trillion dollar industry, there are huge numbers of industry participants with their own agenda.  Analysts want to recommend the next great stock to buy, institutions want to sell you their new hot investment product, and everyone seems to have an opinion on where the market is headed.  Filtering out all the noise and relying on your investment strategy is difficult, not to mention lacking in excitement.  However, it is the only method proven to work over long periods of time and through different market cycles.  As Warren Buffett says, “Investing is simple, not easy.” The steps listed in this letter are by no means comprehensive, but they are critical building blocks in any prudent investment approach.  The successful investor will be the one who designs a solid investment strategy and has the discipline and trust to let it achieve their investment goals.


There is always the risk that an investor may lose money. Even a long-term investment approach cannot guarantee a profit. Economic, political, and issuer-specific events will cause the value of securities, and the portfolios that own them, to rise or fall. Because the value of your investment in a portfolio will fluctuate, there is a risk that you will lose money. The information provided herein should not be construed as a recommendation to purchase or sell any particular security or an assurance that any particular security held in a portfolio will remain in the portfolio or that a previously held security will not be repurchased. It should not be assumed that any of the transactions discussed herein have been or will prove to be profitable or that future investment decisions will be profitable.

1. Several academics conducted a study on the recommendations made by Jim Cramer on Mad Money and found that an investor who followed his advice would experience no long-term outperformance, and would, in fact, suffer significant underperformance in the short run (see references).
2. Calculated as the difference between S&P 500 returns and returns on 10-year US Treasuries.
3. Active fund management is defined as the process of speculatively picking assets for a portfolio with the intention of outperforming a particular index.
4. See, for example, the most recent DALBAR Quantitative Analysis of Investor Behavior.
5. Brad Barber and Terrance Odean
7. The white paper can be found at http://www.empirical.net/portfolio-tax-management/
8. See, for example, Empirical’s Dynamic Income Distribution Approach (http://www.empirical.net/wp-content/uploads/2012/05/12Q1-Newsletter-Dynamic-Income-Distribution-System-.pdf)

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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