Rate of Return: How to Get the Most Bang for Your Investment Buck
By A. Andrew Raub
Rate of return is typically everyone's favorite thing to talk about when it comes to investing. After all, this is where the payoff is, isn't it? When it comes to return, you hear about the extremes of mega gains and tragic losses. But, is there a way to avoid the roller coaster highs and lows and still come out ahead?
In my last two columns, we examined risk and time as integral concepts to investing. Now, let's look at the third leg of investing—rate of return—and see how the pieces fit together. Rate of return is normally thought of as being the result of three decisions:
- Asset allocation—how the investments are divided up or diversified
- Market timing—the art of buying low and selling high
- Investment selection—the ability to consistently choose the best performing investments
Studies measuring the effect of diversification, market timing, and investment selection have consistently shown that the asset allocation decision (how your investments are diversified among various asset classes) has the most significant impact on long-term performance. More than 90 percent of the variations in returns are due solely to how the assets of a portfolio are divided up. Surprisingly, market timing and stock selection make very little difference over time. This is why diversification is your most critical investment decision, and why we will discuss return in terms of diversification (Markowitz, Harry; Journal of Finance, Volume 7, 1952.).
In case you're not convinced, let's discuss that last 10 percent—stock selection and market timing. Is it possible to consistently choose the best performing investments? Does it even matter?
If you were to examine a chart of the best and worst performing asset classes each year for the past twenty years, you would quickly realize that performance is entirely random. One year growth stocks are the clear winner and bonds may come in last, and the next year different categories will take their place. So what should you do with this information? Invest in the previous year's loser and assume it will come back? Or stick with the winners, as most of us do?
One study from Morningstar Associates compares three hypothetical investment approaches from January 1, 1985 to December 31, 2004. In each approach, $10,000 was invested on January 1 of each year based on the previous year's annual index returns.
The three hypothetical approaches were defined as follows:
- Contrarian Approach—$10,000 is invested at the beginning of each year in the worst-performing category of the prior year.
- Bandwagon Approach—$10,000 is invested at the beginning of each year in the best-performing category of the prior year.
- Diversified Approach—$10,000 is invested equally among the eight categories at the beginning of each year.
The result? Over a twenty year period, the Contrarian Approach would have earned an 8.6 percent annual return, the Bandwagon Approach a 10.3 percent annual return, and the Diversified Approach an 11.5 percent annual return. Clearly, history shows that the diversified approach takes the guesswork out of trying to predict the very best investments.
But what about timing the market? Timing is only good if seen in hindsight. No one consistently knows the best and worst time to be in or out of the market until after the fact, and past performance is no guarantee of future return. If you want to be a Peace of Mind Investor then stop trying to time the market. Buying low and selling high is hard work for little to no additional return over the long haul—not a good use of energy.
I hope you see that diversification is the key to realizing more consistent returns on your investments. But what is diversification? It is the art and science of putting together a combination of investments that are non-correlated in their price movements. In other words, you want to build a portfolio in which all the investments don't go up or down in value at the same time or with the same volatility.
Diversification does not guarantee that you will escape the ups and downs of the market. It does not guarantee to produce the highest possible rates of returns. On the other hand, proper diversification has proven to produce more predictable returns for given levels of risk over a long period of time. It will tend to smooth out the ups and downs inherent in the market—those ups and downs that can rob you of your Peace of Mind.