By Jack M. Forehand (@practicalquant) —
There are so many interesting things to debate in investing. The active vs. passive debate has been the subject of more articles than I can count. Although the conclusion that most people should invest passively is clear, there are many nuances to it that continue to be debated every day. And for those people that do decide to be active, there are a variety of decisions that come along with that. For example, whether to invest in value or growth, and which manager to pick within that style. For factor investors, which factor or factors to follow can be another significant decision.
The interest in these types of decisions is very high and so they are all widely covered in the financial press and on blogs like this. We write about many topics on our blog and have written over 3000 posts since 2009, but our article on whether the Price/Book factor is cheap two weeks ago was the most read post we have ever produced by a wide margin. It also generated more back and forth debate than any post we have ever done. Neither of these was due to my amazing writing (although I wish it was). It is more a sign of how much interest there is in these kind of topics.
But there is a problem with focusing on the more detailed decisions in investing: none of them are the decisions that will primarily determine your ultimate success.
Investing success comes down to two major decisions. If you get them right and have the correct expectations, you are likely to meet your goals. If you get them wrong, you are not.
The two decisions are very simple:
- How will you allocate your money among asset classes?
- Will you stay the course during tough times?
Let’s tackle them one at a time.
Decision #1 – What Assets Do You Invest In?
The most important choice you can make in investing is which asset classes you invest in and your allocation among them. This is true for a couple of major reasons. First, in aggregate, asset allocation determines essentially 100% of a portfolio’s return in the long-run, while selection of securities within each asset class has almost no impact. In individual cases, this can obviously not be true, but when all investors are summed up, it is.
To explain why, it is important to understand a basic investing theory. By definition, the total of all managers, both active and passive, will match the return of the asset class they invest in before accounting for fees. Active managers will underperform the passive managers on average by the difference in fees between the two. So on balance, investors will achieve the same return on their equity portfolios as the overall market and bond investors will do the same. As a result, the way to alter long-term returns is to change the allocation between the asset classes, not what you invest in within them.
In a 2010 article for Morningstar Advisor, Thomas Idzorek illustrates this:
To put it bluntly, when it comes to returns levels, asset allocation is king. In aggregate, 100% of return levels come from asset allocation before fees and somewhat more after fees. This is a mathematical truth that stems from the concept of an all-inclusive market portfolio and the fact that active management is a zero-sum game. This fundamental truth is somewhat boring; therefore, it is often lost in the debate, even though it is by far the most important result.
This isn’t to say that picking stocks or picking managers can’t improve returns. It clearly can. But for every person who benefits from things like that, someone else will lose, so as a whole, asset allocation will be the primary driver of returns.
The second reason asset allocation is so important is because it is the major way to control risk within a portfolio. It is essential to match the risk of a portfolio with the goals of the investor whose money it is. If an investor takes money that they need in five years and invests it in the stock market, they are potentially setting themselves up for failure. They may get lucky and invest during a period of strong returns, but things could just as easily go the other way, leading to negative returns and a failure to meet the investing goal. People who invested in the 2007- 2008 timeframe know this all too well. The key is to match the risk an investor can take with the risk they actually take. That is primarily done via asset allocation.
Decision #2 – Will You Stay the Course?
Asset Allocation is very important, but it won’t work without a commitment to the resulting portfolio. There is nothing more damaging to long-term investing returns than human emotion. We have a natural inclination to want to buy when things are high and sell when things are low, even though we know that isn’t what we are supposed to do. We also have a desire to monitor and adjust our portfolios, even though research shows that almost always reduces long-term returns. And we do this irrespective of what we say we will do upfront.
I have reviewed many client risk questionnaires over the years. When we talk to clients that invest with us, they invariably say that they will stay the course during market declines, and won’t make adjustments when their portfolios underperform the benchmark. But the majority don’t do it. We also have seen a direct correlation between how often clients check their accounts and their ability to stick with their strategy. The more they check, the worse they do. The temptation to make changes is just too great.
A Business Insider piece from 2014 sums this up well. It discusses a podcast interview with Jim O’Shaughnessy of O’Shaughnessy Asset Management on Barry Ritholtz’s Masters in Business. Referencing a Fidelity study that looked at how activity in brokerage accounts related to performance, they had the following exchange.
O’Shaughnessy: “Fidelity had done a study as to which accounts had done the best at Fidelity. And what they found was…”
Ritholtz: “They were dead.”
O’Shaughnessy: “…No, that’s close though! They were the accounts of people who forgot they had an account at Fidelity.”
So the more people check their accounts, the worse performance is. And people who don’t check their accounts at all outperform everyone else.
Putting It All Together
As with anything else, investing is about getting the big things right first. Then you can focus on the smaller details. But many investors end up getting caught worrying about all the small details before the big ones. It can be fun and interesting to discuss active vs. passive or which manager to invest with or which factor to follow, but it is important to understand that those things are not likely to be the primary determinant of your long-term returns. So they should be secondary. Focusing on the major questions should be the primary focus if you want to achieve your long-term investing goals.
Photo: Copyright: nomadsoul1 / 123RF Stock Photo
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.