Five Ways to Increase Your Odds of Investment Success
Investing in the stock market, when done properly, can be a great way for individuals to put their money to work and begin to build wealth over time. Improper investing, on the other hand, can lead an individual to experience significant losses. While you cannot ever completely eliminate the possibility of investment losses, there are several things that you can do to greatly increase your odds of long-term investment success. Below, I’ve outlined five that I think are particularly valuable to the average investor.
1.) Diversify Your Investments
You’ve heard the old adage, “don’t put all of your eggs in one basket,” well that sentiment applies to the world of investing as well. While it might be tempting to put a large portion of your money into the latest “can’t miss” tech stock that all the talking heads on CNBC are saying is the next big thing or keep the majority of your net worth within the perceived safety of your company’s stock, don’t do it! Research suggests that an investor that has a well-diversified portfolio with broad exposure across different asset classes and countries will outperform the average investor with large concentrations in one company or sector of the market.
““Diversification is about the closest thing to a free lunch in capital markets, so you may as well get a huge helping of it.”
- Kenneth French”
A properly diversified portfolio does two really valuable things for investors. First, it helps to mitigate and limit the effects of any particular stock’s performance on the overall performance of the portfolio as a whole. Imagine if you were one of the unfortunate Enron employees who had the majority of your 401(k) tied up in Enron stock in 2001 and saw a large portion of your retirement savings practically vaporize overnight. Now, compare that to owning a portfolio that’s made up of thousands of different companies where only a small fraction of a percent is comprised of Enron stock. You might have seen a negligible dip the day that Enron went belly-up, but overall your portfolio will still be fine. That’s the value of proper diversification. It reduces the overall riskiness of the portfolio by eliminating a substantial portion of the non-systematic risk inherent in owning individual securities.
Second, there is also great value found in diversifying globally across different countries and asset classes. Recently, there has been a trend amongst U.S. investors to concentrate the majority of their portfolio holdings in the U.S. stock market. If you look at recent returns, it is understandable why the average investor thinks this is a good idea, as the U.S. stock market has greatly outperformed the international market in recent years. For the five-year period ending October 31, 2018, the S&P 500 Index had an annualized return of 11.34% while the MSCI World ex USA Index returned 1.86%, and the MSCI Emerging Markets Index returned 0.78% resepectively. What investors have seemed to forget, however, is that these returns were preceded by the “lost decade,” where from 2000-2009 the S&P 500 had a cumulative return of -9.1%!
It turns out that it is actually pretty common for the U.S. market to not be the best performer in a given year. If you look at the chart below, you’ll see that only once in the past 20 years did the U.S. stock market have the best returns amongst the stock markets in the developed world. Also, notice how this graph has a patchwork quilt look to it as the various countries’ comparative returns to their peers rise and fall from year to year. By being well-diversified across the globe, you are able to reap the benefits from having some exposure to whichever countries have the best returns in a particular year, while also reducing your exposure to countries that might be having a comparably poor year(s) (such as the U.S. market from 2000-2009).
2.) Invest in Low-Cost Mutual Funds and ETFs
One of the chief components to having a successful investment experience is keeping your expenses low. All mutual funds and ETFs have operating costs that are incurred through the day-to-day operation of running the fund (administrative costs, marketing costs, paying fund managers, etc.). These costs, which are passed on to the fund’s investors, are expressed as the fund’s expense ratio. The expense ratio is the percentage of the average net assets in the fund that is going to pay for fund expenses. For example, if a mutual fund has an expense ratio of 1% it means that one cent of every dollar in the fund is being used to pay for the fund’s operating expenses.
Expense ratios can vary greatly from fund-to-fund and make a significant impact on your investment returns over time. In the chart below, I’ve illustrated this point by highlighting the effects of mutual fund expenses on a hypothetical $100,000 portfolio growing at 8% a year over a 20-year period. As you can see, a seemingly small difference in expense ratios can make quite a pronounced difference to your portfolio’s value over time. Thus, the goal is to utilize mutual funds and ETFs with as low of expense ratios as possible, so that you might benefit from the diversification that these funds provide, while also keeping as much money in your portfolio as possible.
3.) Aim to Be Average
Everyone wants to beat the market, but the fact of the matter is that even professional mutual fund managers struggle to do so. A recent study by Morningstar revealed that of all the actively managed mutual funds in existence, only 14% of equity managers and 13% of fixed income managers survived and were actually able to beat the market over the past 15 years! If you look at the numbers over even longer periods, the percent that outperformed the market drops even lower. While it might not sound all that exciting, in investing, being average and getting market-like returns is a very good goal to aim for. Where can you get market-like returns? Look for solid passive index funds with low expense ratios.
4.) Avoid Knee-Jerk REactions
Fear and greed can make the most brilliant people do really dumb things. Years’ worth of disciplined investing can be undone by moments of panic in the midst of a market correction. If the stock market takes a sudden drop and the talking heads on television start freaking out, don’t give into the hysteria! Stay focused on your long-term goals and don’t make knee-jerk short-term portfolio decisions that can cost you tremendously in the long-term. Getting scared and going to cash for even a few days can cost you substantially.
To illustrate this point, let’s say that you invested $1,000 in the S&P 500 on 01/01/2009 and invested for ten years. If you stayed invested the entire time, your money would have grown to $2,775 by the end of 2018 (excluding dividends). Now let’s assume that you were invested for that same period of time, but you missed just the 10 best market days over that span. Instead of ending with a balance of $2,775, your money would have only grown to $1,722! That’s a difference of 38% for only missing 10 days over 10 years! Many times, these best market days occur shortly after a big selloff and serves as a counterbalance for a day where the market was oversold by traders. Thus, the end result is that by going to cash right after a big market selloff, not only have you realized the loss, but are most likely going to miss out on the rebound thereafter.
So remember, when things get dicey, don’t act in fear and do something that could cost you significantly long-term. If you need some encouragement to fight the fear, read a good article on handling market declines, such as this one, then refocus on your long-term goals.
5.) Rebalance when Necessary
Portfolio rebalancing should be an important part of your long-term investing strategy, as it fulfills two important roles.
First, it prevents your portfolio from taking on too much risk based on your capacity and tolerance for risk. Over time, the more aggressive (i.e. stocks) portions of your portfolio tend to grow faster than the more conservative portions (bonds) of your portfolio. If you never rebalanced, the portfolio that you set-up to be a 60%/40% mix of stocks and bonds could end up looking more like a 80%/20% portfolio over time. Should a market correction happen, you may find that your portfolio is more volatile than you intended. By rebalancing as needed, you prevent this from happening and keep your portfolio in-line with your risk profile.
Second, it systematizes the process of buying low and selling high. You hear people use the phrase all the time “buy low, sell high,” but it turns out that humans are pretty bad at doing this. The reason for this, as mentioned above, is that fear and greed play such a big role in our investment decisions. When the U.S. stock market is soaring and significantly outperforming other sectors, our tendency is to want to put more/all of our money in the U.S. stock market (most likely buying high). Likewise, when the U.S. stock market is going through a correction and we see the values in our portfolio dropping, people tend to freak out and sell (most likely selling low). By employing a sound rebalancing strategy, we can take our emotions out of the equation and systematically sell off portions of our portfolio that are potentially overpriced (i.e. those sectors that have grown in relative size in our portfolio) and buy assets that are potentially underpriced (those sectors that have decreased in relative size in our portfolio). If done effectively, research has found that you can expect to increase the average annual rate of return for your portfolio over time by nearly 40 basis points (.39%).
Conclusion
While there’s always a degree of risk that an investment could lose you money, by utilizing and sticking with the tips above, you will increase your odds of having a successful investment experience. If you have any further questions about investing or need guidance in what’s best for you personally, feel free to email me at daniel@sweetgrassfp.com or schedule a free introductory consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
