Today's investors are all looking for ways to earn higher returns. Here are some tried-and-true tips to help you improve your returns and possibly avoid some costly investment mistakes. For example, should you choose equity or bonds or both? Should you invest in small companies or large companies? Should you choose an active or passive investment strategy? What is rebalancing? Read on to glean some investor insights that stand the test of time.
1. Equities Over Bonds
While equities do carry a higher risk than bonds, a manageable combination of the two in a portfolio can offer an attractive return with low volatility.
For example, during the investment period from 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 9.7% while long-term U.S government bonds averaged 5.6% for the same period.
If you then consider that the Consumer Price Index (CPI—a standard measure of inflation) for the period was 3%, that brought the adjusted real return down to 6.9% for stocks and 2.5% for bonds. Inflation can erode purchasing power and returns, but equity investing can help enhance returns making investing a rewarding venture.
2. Small vs. Large Companies
The performance histories of U.S. companies (since 1926) and international companies (since 1970) show that small-capitalization companies have outperformed large-capitalization companies in both the U.S. and international markets.
Smaller companies carry a higher risk than large companies over time because they are less established. They are riskier loan candidates for banks, have smaller operations, fewer employees, reduced inventory, and, typically, minimal track records. However, an investment portfolio that tilts to small-to-midsize companies over large size companies has historically provided higher returns than one that tilts to large-cap stocks.
U.S. small companies outperformed U.S. large companies by an average return of approximately 2% per year from 1926 to 2017. Using the same small-cap theory, international small companies outperformed international large companies by an average of 5.8 per year during the same period. The graph below shows the average annual index returns for both large and small companies from 1926 to 2010, and this trend has not changed from 2010 to 2018, according to US News.
3. 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 costs than 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 passive management since it requires the insights of high-priced research analysts, technicians, and economists who are all searching for the next best investment idea for a portfolio. Because active managers have to pay for fund marketing and sales costs, they typically attach a 12b-1, annual marketing or distribution fee on mutual funds, and sales loads to their investments so that Wall Street brokers will sell their funds.
Passive management is used to minimize investment costs and avoid the adverse effects of failing to predict future market movements. Index funds use this approach as a way of owning the entire stock market versus market timing and stock picking. Sophisticated investors and academic professionals understand 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?
- A $1,000,000 passively-managed portfolio with a 0.40% expense ratio will cost $4,000 per year for the investments.
- A $1,000,000 actively-managed portfolio with a 1.20% expense ratio will cost $12,000 per year for the investments.
4. Value vs. Growth Companies
Since index tracking has been available, value companies have outperformed growth companies in both the United States 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 that tilts toward value companies above growth companies has historically provided higher investment returns.
Growth stocks tend to have high stock prices relative to their underlying accounting measures, and they are considered healthy, fast-growing companies that typically have 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 poor outlook for the future. Several value companies will offer an annual dividend payout for investors, which can add to the investor's gross return. This helps if the stock price has a slow appreciation for the given year. The irony is that these distressed value companies have significantly outperformed their healthy growth counterparts over long periods as the graph below illustrates.
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) to a portfolio with an appropriate percentage allocation to each class. Since asset classes have different correlations with one another, an efficient mix can dramatically reduce the overall portfolio risk and improve the expected return. Commodities (such as wheat, oil, silver) are known to have a 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%. However, a diversified portfolio with various asset classes would have enjoyed considerably different results.
Over time, a 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 affecting investment decisions. Rebalancing can enhance portfolio performance and return a portfolio to your original level of risk tolerance.
The Bottom Line
Despite how complicated portfolio investing has become over the last several decades, some simple tools have proved over time to improve investment results. Implementing tools such as the value and size effect along with superior asset allocation could add an expected return premium of up to 3% to 5% per year to an investor's annual return. Investors should also keep a close eye on portfolio expenses, as reducing these costs adds more to their return instead of fattening the wallets of investment managers on Wall Street.