It is important to remember that higher risk doesn’t necessarily equate to higher returns.
Tumultuous, volatile and uncertain … these are a few words (albeit extreme ones) an investor might choose to describe the first half of this year.
We’ve seen a political outsider sworn into the White House, central banks tentatively emerging from years of stimulus and low interest rates, tense elections in France and the UK and a watching brief on China as its economic growth engine manages to keep ticking over.
There has certainly been no shortage of news to keep investors awake at night, not to mention jumpy during the day. Even the experts — self-proclaimed and actual — struggle to agree on what is important. So what actually matters when it comes to investment success?
Before making an investment decision, investors should consider what they can control and what they can’t.
Typically, the thing we devote the most attention to — the market — is the thing we have the least control over. We can estimate future returns of the market, but we can’t control what they will actually be.
Our outlook for asset returns over the next 10 years are about 5 to 9 per cent annually for equities and around 2 to 3 per cent for bonds. For some, this may not be what is required to reach a particular investment goal. Or perhaps it just doesn’t seem attractive compared with the returns we have experienced over the past few years.
Search for returns
Some investors address the low-return outlook by investing in riskier assets — switching bonds for stocks, or low-risk government for high-yielding debt. It is important to remember, however, that higher risk doesn’t necessarily equate to higher returns.
While we may have some control over the amount of risk that we take through the portfolio construction process — setting asset allocation or the degree of active management in a portfolio — we can’t control the resulting returns.
So rather than reaching for more risk, consider what is controllable. For example, diversification.
Before the financial advice industry and business media were invented, investors had to look elsewhere for asset allocation tips. Perhaps the first such advice came from the Talmud, about 1800 years ago. It advised diversification across three assets – land, cash, and stock (the type kept on shelves, not in an online trading account).
Thankfully, with the advent of managed funds and exchange traded funds (ETFs), diversification across a wider investment universe is simpler and more accessible than it was in antiquity. Investing across a broad range of asset classes and securities is an effective way to mitigate some of the risk that comes with investing. And it is something well within the control of all investors.
Through this control, investors should feel empowered to spread their portfolio across hundreds of shares and bonds around the globe via well-diversified investments, rather than just a handful of Australian shares or an investment property.
For some investors, this will require a change in the way they think about investing, which can be difficult.
Similarly, it can be difficult sticking to a new diet, exercise or savings plan. But despite the challenges in being self-disciplined, it is also something within our control. The long-term benefits that may come with disciplined behaviours are clear, but making a change can be trying.
Just as the impact of poor decisions on diet and exercise are well-known, so too is the impact of poor investment discipline.
For example, there is a wealth of evidence that demonstrates the appalling ability of investors of all stripes to time the market. Studies from academia, and those we have completed at Vanguard, show that the average investor underperforms the market by several percentage points a year through failed attempts to time the market.
This can also be the case when investors are using managed funds. Our research shows that, by panicking and redeeming from a fund when markets are down or buying in only when an asset class is peaking, investors can actually underperform a fund they are invested in. In the case of equities, this can be to the tune of 1.5 to 2 per cent over a year on average.
Resisting the siren call of market timing can be challenging, but for those with the discipline to do so comes the higher probability of long-term investment success.
A good antidote to this can be a dollar-cost averaging approach, whereby an investor contributes a set amount of money into their portfolio on a regular basis, regardless of market conditions. This method helps not only to ensure disciplined and consistent savings toward an investment goal, but helps smooth out the risk of buying at the “wrong” time.
For those without this kind of discipline, a trusted financial advisor can help maintain a focus on long-term objectives through coaching and timely advice.
Achieving an investment objective does indeed require disciplined savings — that is, contributions towards your portfolio. And for these savings to grow, a sound investment strategy is required. But the relationship between savings and investing can be a little give and take.
As painful as it might be to defer spending and save more, if the market is not delivering sufficient returns the shortfall can be made up from increased savings. While we can’t control portfolio returns, we can control how much we save.
In that sense, when you find yourself asking how the next central bank decision, political vote or diplomatic crisis might affect your portfolio, consider instead your risk, diversification and regular savings plan – the things you can control.
Scott Pappas is an investment analyst in Vanguard’s global Investment Strategy Group