6 Ways To Improve Your Portfolio Returns Today

By Steven Merkel AAA

Today's investor is faced with several challenges as they look for a comfortable way to earn higher returns on their money above the current certificate of deposit (CD) and interest rates. Now-a-days, they'll find investment products that can't be understood, excessively high fees, high volatility in almost every market and products like hedge funds and derivatives that make everyone rich except for the investor. So, here are a couple of tips to help you improve your returns and possibly avoid some costly investment mistakes. (For more, see Top 4 Strategies For Managing A Bond Portfolio.)
TUTORIAL: How To Guide: Diversified Portfolio

Equities Over Bonds
Despite the high volatility in the stock markets over the last decade, the equity markets have consistently outperformed the bond markets over time. While equities do carry higher risk than bonds, a manageable combination of the two in a portfolio can offer an attractive return with low volatility.

If we take a look at a broad investment period of 1926 (when the first tracking data was available) through 2010, the S&P 500 Index (500 U.S large cap stocks) achieved an average gross annual return of 9.9% while long-term U.S government bonds have averaged 5.5% for the same period.

If you then consider that the Consumer Price Index (CPI - a standard measure of inflation) for the same period was 3.0%, that would bring your adjusted real return down to 6.9% (stocks) and 2.5% (bonds). Inflation can erode one's purchasing power and returns, but equity investing can help enhance returns thus making investing a rewarding venture. (See why investors today still follow this old set of principles that reduce risk and increase returns through diversification. For more, see Modern Portfolio Theory: Why It's Still Hip.)

Figure 1: Average Annual Returns 1926-2010
Data Source: Dimensional Matrix Book 2011, S&P500 Index and Long-term Government Bonds from the "Stocks, Bonds, Bills, and Inflation Yearbook", Ibbotson Associates, Chicago.

Small Vs. Large Companies
If you look at the performance history of U.S. companies (since 1926) and international companies (since 1970) when index tracking data was first available, you'll find that small capitalization companies have outperformed large capitalization companies in both the U.S. and international markets.

Smaller companies will carry higher risk than large companies over time because they are not as well-established as their larger counterparts. They are riskier loan candidates for banks, have smaller operations and employees, reduced inventory and, typically, have little track record. However, an investment portfolio tilt to small-to-mid size companies over large size companies has historically provided higher returns than just buying large cap stocks.

U.S. small companies have outperformed U.S. large companies by an average return of 2.1% per year since 1926. Utilizing the same small cap theory, international small companies have outperformed international large companies by an average of 5.8% per year since 1970. The graph below will show the average annual index returns for both large and small companies since data tracking has been available. (For related reading, see 5 Popular Portfolio Types.)

Figure 2: Average Annual Returns 1926-2010 (U.S. Stock Indexes), 1970-2010 (Int\'l Stock Indexes)
Data Source: Dimensional Matrix Book 2011. Fama/French US Small Cap Index 1926-2010 (US Small Caps); S&P 500 Index 1926-2010 (US Large Caps); 50% UK Small Cap Index & 50% Japan Small Cap Index 1970-1981 (Int\'l Small Caps), Dimensional Int\'l Small Cap Index 1982-2010 (Int\'l Small Caps), MSCI EAFE Index 1970-2010 (Int\'l Large Caps).

Managing Your Expenses
How you invest your portfolio will have a direct impact on the cost of your investments and the bottom line investment return that goes into your pocket. The two primary methods to invest are through active management or passive management. Active management has significantly higher cost than that of passive. It is typical for the expense difference between active and passive management to be at least 1% per year.
Active management tends to be much more expensive than its passive counterpart since it must employ high-priced research analysts, technicians and economists that are all searching for the next best investment idea for your portfolio. Because active managers have to pay for fund marketing and sales costs, they typically attach 12b-1 and sales loads to their investments to get the Wall Street brokers to sell their funds. (For more, see Active Management: Is it Working For You?)

Passive management is used to minimize investment costs and avoid the adverse effects of failing to predict future market movements. Index funds are known to utilize this approach as a way of owning the entire stock market versus market timing and stock picking. Sophisticated investors and academic professionals understand the reality that most active managers fail to beat their respective benchmarks consistently over time, therefore; why incur the additional costs when passive management is typically three times less expensive. (For related reading, see Create Your Own U.S. Equity Portfolio.)

$1,000,000 passively managed portfolio with a 0.40% expense ratio will cost $4,000 per year for the investments.

$1,000,000 actively managed portfolio with a 1.20% expense ratio will cost $12,000 per year for the investments.

Value Vs. Growth Companies
Since index tracking has been available, value companies have outperformed growth companies in both the U.S. and international markets. Academic financial professionals that have studied both value and growth companies for decades, have commonly referred to this as the "value effect." A portfolio tilt to "value" companies over "growth" companies has historically provided higher investment returns.

Growth stocks tend to have high stock prices relative to their underlying accounting measures, and they're considered to be a healthy, fast-growing company that typically has little concern for dividend payouts. Value companies on the other hand, have low stock prices relative to their underlying accounting measures such as book value, sales, and earnings. These companies are distressed companies and may have poor earnings growth and a depressing outlook for the future. Several value companies will offer an annual dividend payout for investors, which can add to the investor's gross return which helps if the stock price has slow appreciation for the given year. The irony is that these "distressed" value companies have significantly outperformed their "healthy" growth counterpart over long periods of time as the graph below will display. (For related reading, see 5 Must-Have Metrics For Value Investors.)

Figure 3: Average Annual Returns 1975-2010
Data Source: Dimensional Matrix Book 2011. Fama/French US CRSP Small Cap Index (US Small Value); Fama/French US CRSP Small Cap Growth Index (US Small Growth); Fama/French US CRSP Large Value Index (US Large Value); Fama/French US CRSP Large Growth Index (US Large Growth); MSCI EAFE Large Value Index (Int\'l Large Value); MSCI EAFE Large Growth Index (Int\'l Large Growth).

Asset Allocation/Diversification
Asset allocation and diversification is the process of adding multiple asset classes that are different in nature (U.S. small stocks, international stocks, REITs, commodities, global bonds, etc …) to a portfolio with an appropriate percentage allocation to each class. Since asset classes have different correlations to one another, an efficient mix can dramatically reduce the overall portfolio risk and improve the expected return. Commodities (such as wheat, oil, silver, etc…) are known to have low correlation to stocks, thus they can complement a portfolio by reducing the overall portfolio risk and improving expected returns.

"The Lost Decade" has become a common nickname for the stock market period between 2000 through 2010 as the S&P 500 Index returned a measly average annual return of 0.40% for the period. However, had you diversified your portfolio among various asset classes such as investments similar in nature to the following different indexes, you would have had much different results:

Asset Class Index Annual Average Returns
(years Jan 2000- Dec 2010)
S&P 500 Index 0.40%
US Small Cap Value Index 12.1%
DOW Jones UBS Commodity Index 8.0%
DOW Jones US Select REIT Index 12.1%
MSCI Emerging Markets Index 10.9%
Barclay\'s Capital US Govt/Credit
Intermediate Bond Index

:For more, see 2000-2009: The Lost Decade.

Over time, your portfolio will drift away from its original asset class percentages and should be put back in line with the targets. A 50/50 stock to bond mix could easily become a 60/40 stock to bond mix after a prosperous stock market rally. The act of adjusting the portfolio back to its original allocation is called "rebalancing."

Rebalancing can be accomplished in three ways:

  • Adding new cash to the under-weighted portion of the portfolio.
  • Selling a portion of the over-weighted piece and adding this to the under-weighted class.
  • Taking withdrawals from the over-weighted asset class.

Rebalancing is a smart, effective, and automatic way to buy low and sell high, without the risk of emotions to get in the way of your investment decisions.A study done by Goldie & Murray in 2010 for the period of January 1, 1990 to December 31, 2009, took a typical 70/30 stock/bond index mix and looked at the effect of rebalancing the portfolio annually versus letting the same portfolio untouched. The rebalanced portfolio had a gross total return of 449.23% for the period, whereas; the untouched portfolio had a total return of 366.62%. Rebalancing can accomplish two very important aspects to investing: enhance portfolio performance and return your portfolio to your original level of risk tolerance. (For related reading, see Rebalance Your Portfolio To Stay On Track.)

The Bottom Line
Despite how complicated portfolio investing has become over the last several decades, there are still several simple tools like those mentioned above that have been historically tested to improve investment results. Implementing tools like the "value" and "size" effect along with superior asset allocation, could add an expected return premium of up to 3-5% per year to your annual return. Remember to keep a close eye on portfolio expenses, as this adds more to your bottom line, instead of fattening the wallets of the investment managers on Wall Street. (For more, see 6 Asset Allocation Strategies That Work.)

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