Explanation-based investing: a better name than passive?
- Robin Powell
- 3 minutes ago
- 5 min read
Robin writes:
A couple of weeks ago I asked whether "passive investing" is the right name for a strategy that consistently lowers costs, reduces regret, and improves returns. The response was striking, and one contribution in particular stood out. In this piece, William Morris, Head of Investments, Weatherbys Private Bank, introduces a new term — explanation-based investing. His view is that what investors need most isn’t the energy of activity or the apathy implied by passivity, but a clear explanation rooted in evidence. I’m delighted to share his perspective as part of this ongoing conversation on TEBI.
If you are reading this, there is a good chance you are already convinced that evidence-based investing is the way to go. Rather than let a supposed guru pick stocks, look to the evidence: the vast majority of active managers have, after fees, underperformed index-tracking funds.
But if we live by the empirical sword, we shall surely die by it, too: what of the active manager that has outperformed? There will usually be at least a few. Why should investors not give the star performer their business?
This is a question which data alone cannot answer.
Noticing patterns in charts and extrapolating them is dangerously common in the investments industry. Market gurus will show you a graph of yesteryear and then, in a sleight of tense, insist that past is present again.
But even trends lasting for aeons can — unpredictably — end.
For example, if we relied only on precedent, we would — if we had existed back then to make observations – expected precisely zero life to emerge on primordial Earth, because we had recorded nothing but billions of years of fruitless chemistry.
But then things changed. We still do not know, and may never know, the real reason, but the best explanation we have is that organic matter started to self-replicate in an entirely novel way. One thing led to another, and in particular to you reading this right now.
A more salient example is real wages. For most of the thousand-year history of England, they oscillated between £30-70 per week — until the Enlightenment sparked unheard-of increases in productivity, and salaries skyrocketed north of £600 per week within a century.
What explained that leap? The somewhat meta answer is: better explanations. No longer was knowledge handed down by fallible yet uncorrectable authorities. Instead, scientists sought to get closer to the truth of reality. Not for nothing was the motto of the Royal Society, “Nullius in verba” (“Take nobody’s word for it.”)
If not from god or king, how was new knowledge generated? By what Karl Popper termed “conjecture and refutation”. Crucially, those conjectures are creative in nature: hitherto unimagined notions. Creativity is what makes new knowledge unpredictable in advance.
Popper also argued that all evidence is theory-laden, by which he meant that observational data is not magically uploaded to our brains: it must come via our fallible senses, and possibly also our fallible instruments. If the scales seem to suggest you weigh a trillion tonnes, your first thought is probably not to go on a crash diet, but that something’s gone awry with the machine — that is a conjecture to explain the problem.
Ultimately, new knowledge is new wealth: new ways of achieving our ends, by transforming the world through uncapped advances in rational understanding. Uncapped, because we shall remain ever fallible — there will always be a cloud of doubt, always the potential for improvement.
This was understood by Adam Smith, who wrote in The Wealth of Nations that ingenuity is necessary to transform raw materials into something valuable; after all, uranium sat unwanted in the ground for millennia before an understanding of nuclear physics promoted it to “resource”.
New wealth does not spontaneously appear in bank accounts, but is instead embodied in research papers, designs, machinery, and the minds of those who dream of a better future.
Turning back to our star performer: one possible explanation for their extraordinary returns is that they just got lucky. But ‘luck’ is not a terribly good explanation.
A better one might be that, considering the range of stock-picks (themselves conjectures) across the universe of active managers, it would have been almost impossible for there not to have been at least one who beat the index. In simple terms, if each manager favours a particular sector, then one of them will surely beat the market, just as one shall inevitably bring up the rear.
Another explanation is that it is simply not possible to predict future share prices. After all, they are also unpredictably creative conjectures – of the value of a company. Free markets allow participants to impart their distributed knowledge of all sorts of pertinent information into their bids and offers. In this sense, they act as error-correcting mechanisms.
Contrast that with command economies, where a hubristic supremo dictates what prices should be, or which industries should be the recipients of investment. History is replete with proofs of the idea that this is the route to prosperity.
Index-tracking funds are to free markets what stock-pickers are to central planners. This is the crucial epistemological link between wealth creation and successful investing: markets assimilate information and correct errors better than any single individual.
This explanation for the success of index-tracking funds has a reach into the future which no amount of evidence could ever amass. And it is only explanations that have the power to dismiss the claims of star-performers that their prowess will persist.
Evidence will always play a crucial role in arbitrating amongst competing theories. But it is not the font of progress.
To rely on evidence alone – the fallacy of empiricism – is to ignore the regulatory refrain that past performance is not a guide to the future.
And so, when we think of evidence-based investing, or for that matter, evidence-based medicine, or evidence-based policy, let us instead prefer explanations.
For further reading, I strongly recommend “The Beginning of Infinity” by David Deutsch, which heavily inspired this article.
William Morris is Head of Investments at Weatherbys Private Bank and long-time advocate of evidence-based approaches to portfolio management. His suggestion of “explanation-based investing” is one contribution to a broader debate. We’d still love to hear from readers with their own ideas for a better alternative to the label passive investing. Do share your thoughts.
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