Why does it appear like some investors can do no wrong when it comes to investing, while others struggle to make sense of what they're doing wrong and how to correct it? Did I pick the right stocks? Time the market just right? Choose the right fund manager? To achieve investing success, most people will recommend those strategies.
The reality is, there are only a handful of key factors that determine what type of an investment experience a person will have and whether or not they are successful as an investor.
1. Investor Behavior
This is by far and away the most important factor influencing investor success. Is the investor a patient buy and hold investor, or someone who was constantly reading news articles, acting on their emotions and chasing the investment fad of the day? When you consider the irreparable damage panic selling can cause when the market is down 40%, the importance of behavior on investor success cannot be overstated. (For more, see: 5 Things to Know About Asset Allocation.)
2. A Financial Plan
The presence of a goal-driven financial plan that spells out the purpose for investing is crucial to investor success. A financial plan can help investors define the financial goals they are targeting and provide them with a plan of action to achieve them. How they invest then becomes a simple matter of what is required to achieve their financial goals. In this way, a financial plan constantly reminds investors of the purpose of their investments, which shapes their attitudes about investing and puts everything in the proper perspective. Investors acting upon a written plan are less likely to abandon their investments or make detrimental changes in response to what is going on in the market.
3. Asset Allocation
An investor’s mix of stocks versus bonds determines the vast majority of the risk and return characteristics of an investment portfolio. Successful investors take the time to make sure their stock and bond allocations give them the best chance of achieving their unique goals. In addition to making deliberate decisions about big picture, asset allocation decisions like stocks versus bonds, successful investors also pay attention to their sub-allocation, how they split the larger asset classes (stocks and bonds) into smaller ones. They make deliberate decisions about how much to hold in U.S. versus international stocks, large-cap versus small-cap stocks and value versus growth stocks.
But a word of caution: a lot of investors (and advisors as well) get caught up in the minutia of sub-allocation decisions and waste their time. Whether investors hold 2% or 3% of their portfolio in a particular asset class is not going to make a material difference in their results and is not worth worrying about. I think the most important thing about sub-allocation and investor success is diversification. Successful investors sensibly spread their money around within asset classes. The more diversified the investment portfolio, the more likely the investor is to be successful.
Diversification is imperative to long-term investment success. If an investor spreads their money around to thousands of companies throughout the world, no single company, country, or asset classes performance class can sink the performance of the entire portfolio. Diversification also ensures investors will reap investment returns when and where they show up. (For more, see: Pay Attention to Your Fund’s Expense Ratio.)
The return of the stock market as a whole is driven by a relative handful of star performing companies or industries. Since it is impossible to know who these star performers will be in advance, the only way to ensure you will own them is by committing to owning everything, all the time. This also means you will never be concentrated in the “winning” asset class or company over a particular time period. Though it may be tempting to try to concentrate all your money in one hot sector or asset class or “the next Amazon,” the returns of individual stocks and sectors can vary even more wildly than returns of broad asset classes. Even the most financially stable companies can suffer from mismanagement and become worthless as investments - a concentration risk no investor needs to take.
5. Low Costs
The return you as an investor ultimately get to take to the bank is the return of your investments minus the costs. It is simple arithmetic that the higher the costs of investing, all other things equal, the lower the return the investor receives. Costs show up in many forms. One of the more obvious ones is expense ratios on investment funds. Though you still see expense ratios over 1%, in most cases you can find a passively-managed index fund covering the same asset class for a fraction of that cost, sometimes as low as 0.05% for something like a simple S&P 500 index fund.
Another is turnover, which is how much the fund is buying and selling or “turning over” its investments. Higher turnover leads to higher transaction costs which serve as a drag on performance. Successful investors do their homework and make sure to keep costs as low as possible.
The Bottom Line
Investing might seem like it takes some type of special magic that most people simply don’t have. But this is not the case. By behaving appropriately, planning diligently and making deliberate decisions about investment portfolios, any investor can put the wind at their back and set themselves up for investment success. (For more from this author, see: 6 Steps to Build a Diversified Portfolio.)