Investment management is all about deciding how best to put your money to work to achieve your financial goals. Understanding risk is a key part of the investment planning process. A smart investor needs to fully comprehend how risk is measured and its potential effect on long-term portfolio performance. This article outlines 5 principles of investment management that can increase your chance of success.
Use Low-Cost Index Funds
Index funds are investment vehicles meant to replicate the total market or a subsection of the market (equity or bond). Most index funds are constructed to match the performance of the corresponding market or bond index. Examples of indices that have indexed portfolios constructed around them by mutual fund families include the S&P 500 Index for the domestic market, and the Barclays Capital US Aggregate Bond Index for the bond market.
An indexed portfolio is a passive strategy that has as its foundation the belief that capital markets are efficient and fully reflect all information in securities prices. As a result, market timing and the search for undervalued securities is an activity that is unlikely to outperform the market. In fact, research shows that 80% of active fund managers underperform their benchmarks.1 (Through January 2008, the Vanguard S&P 500 Index Fund outperformed 78% of all US large-capitalization stock mutual funds over the prior 15 years. In the same period, 80% of intermediate-term US bond mutual funds underperformed the Barclays Capital US Aggregate Bond Index. Of the 20 top-performing US stock mutual funds between 1983 and 1993, 16 failed to match the market return in the subsequent decade.)
Diversify Across Multiple Asset Classes
One of the most important decisions in building a successful investment portfolio is asset allocation. Asset allocation is not about picking individual securities. Rather, it focuses on combining different asset classes—such as stocks, bonds, and cash equivalents—whose risk and return potential complement each other to provide lower volatility, and thus a steadier pattern of returns. This is because different types of investments tend to behave differently under the same market conditions.
Using asset allocation, you identify the asset classes that are appropriate for you and decide the percentage of your investment dollars that should be allocated to each class (eg, 70% to stocks, 20% to bonds, 10% to cash equivalents).
The Brinson study revealed that asset allocation decisions account for roughly 92% of a portfolio’s performance.2 This finding is contrary to what one may expect to determine a portfolio’s performance. Many people who believe that superior stock selection and market timing are the keys to investment performance would be surprised to learn that these 2 factors account for only 6% of what actually determines performance. Simply put, the key to a consistently performing portfolio is well-executed asset allocation, not picking “hot” stocks or trying to time the market.
You can also diversify within a single asset class by blending styles. Stocks and bonds are not the only pairings that allow investors to exploit low correlations. Historically, investing in different equity styles (growth vs value), capitalization (large cap vs small cap), and equity markets (US vs international) have provided opportunities to enhance returns while reducing risk.
How you allocate your assets depends on several factors, including your investment objectives, attitudes toward risk and investing, desired return, age, income, tax bracket, time horizon, and even your belief in what the market will do in the short- and long-term.
Minimize Investment Expenses
The less you pay in advisory fees, commissions, and management fees, the more money you keep. Many physicians will find that having most or all of their money invested in a few diversified, low-cost index funds can help them minimize their investment expenses and portfolio complexity while still capturing market returns. In a study on growth in the mutual fund industry, Martin J. Gruber found that the worst performers had the highest average expense ratio, and that the return differences between the worst and the best funds exceeded the fee differences.3
A 2010 Morningstar report showed that “expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”4 To hold on to even more of your return, you can also manage your portfolio for tax efficiency.
If you are unsure about your fund’s expenses, go to www.finra.org and use their Fund Analyzer, which offers information and analysis on more than 18,000 mutual funds, ETFs (exchange-traded funds), and ETNs (exchange-traded notes). This tool estimates the value of the funds and the impact of fees and expenses on your investment, and enables you to look up applicable fees and available discounts for funds.
Create a Long-Term Plan, and Stick with It
During periods of economic uncertainty, financial markets are often characterized by wide swings in market value. When markets fall sharply, some investors will panic and sell part or all of their holdings, and shift into “safer” investments. Such emotion-based selling after a market decline simply turns paper losses into realized losses and limits any possible gains should the market recover.
Disciplined rebalancing helps to keep your portfolio well-positioned for the long-run. If you ignore rebalancing, your portfolio allocations can shift in ways you never intended—and so can your risks. Rebalancing involves restoring your original asset allocation by shifting your funds among investment categories to regain the ratios you decided on when you first designed your portfolio.
“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful,”5 stated Warren Buffett.
Manage Downside Risk and/or Work with a Financial Advisor
Everyone knows that the stock market is risky, but we do not have a good measure of this risk. What we see is volatility, which is a manifestation of risk. Higher volatility means higher risk, yet there is more to risk than just the volatility. Although a riskier portfolio may generate higher returns, it can also generate lower returns than a portfolio that is less risky. Although this may not be apparent when markets rise, it becomes clear when markets fall.
Most mutual funds are made up of a combination of stocks, bonds, and cash equivalents. Where do they stack up with respect to risk and reward? Stocks have the highest potential reward but tend to be the most volatile. Bonds can help provide a stream of income to reinvest in your account, but tend to have less long-term growth potential and are typically less volatile than stocks. Cash-equivalent or money market instruments offer the most stability but very little long-term growth potential. All mutual funds have different degrees of risk, so you can create a portfolio with choices that reflect your own risk tolerance to help you reach your investment goals.
If you think you can make good decisions on when to buy and sell on your own, consider that the statistics on the “do-it-yourself” approach are not encouraging. Findings by Morningstar, a leading mutual fund research firm, compared mutual fund returns with the gains investors actually received. The study showed that investor returns typically lagged fund returns.6 The reason—investors tended to move in and out as markets would rise and fall, often buying high and selling low.
The study covered 10 years through the end of 2012, and showed that funds posted an average annualized return of 7.05% compared with a 6.1% average return realized by investors. (These returns factor in all stock and bond funds that Morningstar tracks. Investor returns are weighted based on asset flows into and out of all share classes of open-end mutual funds.) Although a single percentage point gap may not seem to be a big difference, it can make a significant impact over the long-term return, because of compounding.
There are principles for investment success that apply to each of us, whether we are professional portfolio managers or individual investors. Although much of this can be considered to be so-called common sense by those who are educated about investing, we find that not everyone is aware of these important principles. These 5 principles will likely improve your chances of investment success.
- Benzinga. Active management mediocrity continues. September 10, 2015. www.morningstar.com/news/benzinga/BenzBZW_5829832/active-management-mediocrity-continues.html. Accessed September 17, 2015.
- Brinson GP, Hood LR, Beebower GL. Determinants of portfolio performance. Financ Analysts J. 1986;42:39-44 [Updated 1991;47:40-48].
- Gruber MJ. Another puzzle: the growth in actively managed mutual funds. J Finance. 1996;51:783-810.
- Kinnel R. How expense ratios and star ratings predict success. Morningstar. August 9, 2010. http://news.morningstar.com/articlenet/article.aspx?id=347327. Accessed August 27, 2015.
- Buffett WE. To the shareholders of Berkshire Hathway Inc. Annual letter to shareholders. February 28, 2005. www.berkshirehathaway.com/letters/2004ltr.pdf. Accessed August 27, 2015.
- Kinnel R. Mind the gap: why investors lag funds. Morningstar Advisor. February 4, 2013. www.morningstar.com/advisor/t/70540275/mind-the-gap-why-investors-lag-funds.htm. Accessed August 27, 2015.