Becoming a better investor
Investing isn't as hard as you'd think! History and academic research have shown that there's a right way to invest for the long term: passive investing. By committing to this strategy and adding on a few best practices, you can be a great investor.
In this section, we aim to go over the key principles that'll help you move forward with confidence:
Understand risk and return
When it comes to investing, you have several options: the stock market, bonds, gold — and even Bitcoin. Each of these investments is associated with a different level of return and a different level of risk. By returns, we mean how much an investment is expected to grow over time. By risk, we mean the variability in that return over time.
An investment whose return is relatively certain is considered safe, while an investment whose future return might vary considerably from what we expect (and where losses could be suffered) is considered risky. Both market practitioners and academic economists have long believed investors should receive a higher rate of return for bearing greater risk.
Source: Wealthfront; for more details, see this blog post.
Historical data backs up this belief. For example, government bonds are considered a safer (lower risk) investment, but offer lower returns than stocks. As you can see in the chart above, over a 90 year period, stocks have had nearly double the higher average returns than government bonds, but the additional average return was associated with much greater volatility as is indicated by the risk level.
Your time horizon matters
But how do you know what the right level of risk is for you? The answer to that question largely depends on your risk tolerance and your time horizon.
Your probability of losing money in the market decreases the longer you invest. So if your time horizon is longer, you can afford to put your money in higher risk (and higher return) investments.
Source: Wealthfront; for more details, see this blog post.
The table above reflects the probability of loss over time for a hypothetical diversified portfolio.1 As you can see, there is almost a 37% chance of loss after the first year. The number drops to just over 22% after five years, then down to only 14% after 10 years.
Due to higher volatility in short time horizons, money earmarked to be spent in the next five years should be kept in a liquid, high-yield savings account. This ensures your money will be available when you need it. On the other hand, savings with a longer time horizon should be invested in a globally diversified portfolio of low-cost index funds (also known as "passive investing," which we explain more in the next section).
1. For the purposes of the computations, the expected return of the portfolio was set equal to 5.8%, and its annualized volatility to 14%.
Commit to passive investing
Wall Street "gurus" and TV personalities like Jim Cramer may tempt you into believing that outperforming the market is possible. But historical data and academic research has proven otherwise.
The case against active investing
As our Chief Investment Officer Burt Malkiel explained in his seminal book A Random Walk Down Wall Street, a stock's price incorporates all the available knowledge about the value of the company and the best predictions about the future of the stock. According to Burt, stock-picking is a losing game; you cannot beat the market — the best you can do is to track the overall returns of the financial markets.
But since there's an entire industry devoted to outperforming the market, let's take a look at how active managers do. The table below compares the performance of actively managed large cap equity funds with the performance of the S&P 500 (an index that tracks the performance of the 500 largest public companies in the US).
As you can see, over a 1 year period, about 85% of funds that tried to chase outperformance by actively selecting stocks actually failed to perform as well as the index that simply tracks the overall US stock market. This underperformance is consistent even over longer time horizons.
Choose wisely, choose passive
Rather than attempting to outperform the market, focus on tracking broad market indexes through passive investing. In other words, invest in a portfolio of low-cost index funds and commit to focusing on three specific things that are within your control:
- Diversification: Year to year, one asset class may rise and another may fall. By investing across asset classes, you can insulate yourself, to some extent, from the losses while tracking the broad performance of the overall markets. When evaluating risk-adjusted returns, single asset classes are not expected to match the performance of a well-diversified portfolio.
- Minimize costs: When selecting the investments for your diversified portfolio, be sure to use index funds with low fund fees, so that more of the returns goes in your pocket.
- Minimize taxes: Reducing the taxes you pay leaves more money that can grow for you. There are strategies available to help you achieve this without impacting your overall investment strategy. We get into the specifics in the next section.
One thing worth remembering is that passive investing seeks to maximize your returns over the long run, but that doesn't mean your returns will always be positive. Securities markets can, and often do, decline temporarily. Over the past 50 years, there have only been 16 market corrections, defined as a drop of at least 10%. But the average time to recovery has been just 121 days. This is an important point to consider, especially when it feels like there isn't an end in sight.
Leverage optimization strategies
A huge strength of passive investing is that it leaves human judgement and emotion at the door. By simply committing to a diversified portfolio, your savings will compound steadily over time. In addition, there are a few more rules-based, time-tested strategies that can enhance your after-fees, after-tax returns without requiring you to take on more risk.
Rebalance your portfolio
If the US stock index performs well and foreign bonds perform poorly over the course of a month, then US stocks will end up being a larger portion and foreign bonds will be lower portion of your portfolio than they should be. In order to maintain the expected risk of a diversified portfolio, it needs to be rebalanced periodically.
Keep all fees low
Fees compound, just like returns. Be sure to select an investment advisor that charges low advisory fees, has no hidden fees, and gives you access to low cost investments. For instance, if you invest $10,000 with a high management fee, reducing that fee by 1% means that you will save $1,400 out of pocket over the course of 10 years. To put it another way, that $1,400 would be the equivalent of 10% of your total account value in that tenth year.1
Lower your tax bill
Tax-Loss Harvesting is a strategy that looks for opportunities to lower your tax bill without disrupting your overall investment strategy. When an investment declines, which is a common occurrence in diversified portfolios, this strategy sells the investment and replaces it with a highly similar investment. Through this process, a tax loss is generated — which can be used to offset other taxable items and reduce your tax bill. To see the real life impact of this strategy, read the published results of our tax-loss harvesting strategy.
1. Assumes initial deposit of $10,000, annual market return of 5.25%, and compares 0.25% annual fees versus 1.25% annual fees.
TO SUM IT UP
Investing well is really about getting the highest risk-adjusted returns over time. Passive investing might seem like the more boring way to get there compared to picking a sexy stock in the near-term. But history and academic research show that passive investing is your ticket to success over the long-term.Dive into another question →
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