The Simple, Effective Approach to Investing (Part 1): Where Do Investment Returns Come From?

“Indexing is a successful approach to investing not because it’s simple, but because it has performed so much better than the average active manager (the opposite of indexing), and the simplicity is just an added bonus.”

     -Patrick Geddes, Aperio Group (transparentinvesting.com)

This is part of a four-part series on investing basics. You can follow along with the entire series here:
-Part 1: Where do investment returns come from?
-Part 2: Investment risk and return
-Part 3: Determine your asset allocation
-Part 4: Implementing your investment plan

Last week, I looked at the hard numbers showing that investment professionals can’t pick stocks. It’s certainly counter-intuitive, but it’s also pretty hard to argue with the numbers. But if careful evaluation and selection of stocks can’t beat simple market indices, then how are you supposed to invest?

Well, how about investing in the indices themselves? It turns out that an index investing approach is actually an extremely simple and highly effective way to earn superior investment returns.

As the quotation above says, this approach is not effective because of its simplicity, but rather is an extremely effective approach that just happens to be simple. Over the next few weeks, I’ll have a series of posts that I hope will help to explain how this simple approach works, why it works, and how you can apply it yourself.

In today’s post, I’ll look at where investment returns actually come from and why it matters for your your strategy.

What factors drive returns?

There is much research on the topic of what factors determine an investor’s returns. One short paper that sums it up pretty well can be found here.

What is all comes down to is pretty simple. Over 90% of your returns are determined by just two factors:
1. The return of the markets as a whole.
2. Your asset allocation.

So if the stock market is doing well, your stock investments will likely do well no matter which stocks you’ve actually picked. The opposite is true when the stock market is falling. While you can’t control or predict the various ups and downs of the market, understanding that general market movements play a much bigger role in your returns than your specific stock selection is important to crafting a good strategy. Since you can’t control the market movements, you will determine your individual returns by controlling your exposure to those movements.

This is where your asset allocation comes into play. Very simply, your asset allocation is the percent of your money you dedicate to each kind of investment. At the basic level, you will likely have some percent in stocks, some in bonds, and possibly some in cash. Your specific percentages go a long way towards determining your returns.

As an example, someone who is split 90-10 between stocks and bonds will do much better when stocks are up than someone who is split 50-50. When stocks are down, the person who is split 50-50 will do better. It matters very little which specific stocks or bonds you own, just that you own them at all.

What about the rest of your returns?

As I said above, the research indicates that more than 90% of your returns come from the markets as a whole and your asset allocation. The rest comes from the active management of your portfolio. Or in other words, the actual stocks and bonds in which you choose to invest.

There are several reasons why I think this portion can largely be ignored from a strategy standpoint, the biggest of which is again the overwhelming evidence that stock-picking doesn’t consistently work. The numbers show this to be true again and again. When a particular strategy has been shown to be more likely to hurt me than help me, I choose to ignore it and instead focus on the factors that matter and that I can control.

What does all of this mean for you?

All of this is actually very good news for you because it makes investing very simple. There are two main principles you have to accept and follow:
1. Returns are largely driven by overall market forces, not by individual management.
2. The portion of those returns that you as an individual actually experience is primarily determined by your exposure to the markets as determined by your asset allocation.

Based on these main principles, your strategy should be determined essentially as follows:
1. Determine the amount of market exposure you would like to have with your investments.
2. Obtain that market exposure by finding investments that mimic the markets as closely as possible.
3. Do this at the lowest possible cost.

That third point about costs is incredibly important. Every dollar you spend on taxes, fees or commissions is a dollar that isn’t earning compound returns for you. And costs are rather easily controlled and are therefore very much worth focusing on.

Summary

This is some of the reasoning behind why an index investing approach works. Next week we’ll look at some of the ways you can think about applying it yourself as you decide on your own personal investment strategy.

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15 Comments... Read them below or add one of your own
  • J W_Umbrella Treasury May 8, 2013

    Thanks for this excellent, thorough primer, Matt! My husband and I are planning to start investing in the next few months (just small steps at first, a few thousand dollars to start), and your posts will be so helpful.

    Also enjoyed your post on why the pros can’t pick stocks. I think there are some really fantastic investment managers out there (my employer uses an investment firm that has outperformed the S&P500 for every year we’ve used them). But for the average at-home investor, I think we should think carefully about using investment professionals.

  • Cash Cow Couple May 8, 2013

    Good post Matt! Indexing is such a great option for folks. You are doing a great job describing money in layman terms. I’m sure posts like this are immensely helpful to those looking to get started!

  • Matt Becker May 8, 2013

    I’m glad this is helpful! I would agree that there are some good investment managers out there, but you should be somewhat wary of comparisons to the S&P 500. Depending on what they are investing in, it may not be a relevant comparison. You can read this article for a little more explanation: http://www.forbes.com/2010/03/25/investment-advisors-use-poor-benchmarks-personal-finance-indexer-ferri.html.

  • Laurie @thefrugalfarmer May 8, 2013

    Another great post for us as we learn more about investing. Thank you so much for this very helpful info, Matt. We appreciate it!

  • Greg May 8, 2013

    Good, straightforward advice. I am definitely with you that stock picking is risky at best. Just search various “expert” opinions to see the range of differences and what that tells you is nobody knows for sure!

  • Matt Becker May 8, 2013

    Sure! Glad it’s helpful.

  • Matt Becker May 8, 2013

    Thanks John. I would say that it’s a great way to approach investing especially if you’ve done the work to gain knowledge on the topic.

  • Matt Becker May 8, 2013

    Great point. Relying on experts’ predictions is definitely not a useful way to go. Best to make a strategy and “stay the course”, as you said so well in your post.

  • JC @ Passive-Income-Pursuit May 9, 2013

    The funny thing about the 90/10 ratio of returns is that it probably assumes that you’ve created and are sticking with an investment plan. That 10 can quickly grow if you’re constantly changing your investment style and trying to jump in and out of the market.

  • Matt Becker May 9, 2013

    Interesting idea, but jumping in and out of the market is simply a change in asset allocation, which is part of the 90%. If you’re constantly changing your investment style, you’re probably not going to do incredibly well no matter what your strategy is.

    Also, these studies are largely looking at actual mutual funds and institutional investors, not theoretical portfolios. So they are measuring the extent to which actual investor returns were dictated by these different factors.

  • Matt Becker May 9, 2013

    Thanks! I certainly hope they’re helpful.

  • Pretired Nick May 9, 2013

    Nice summary, Matt. I’m actually going to keep this handy so I can send it around when I get this kind of question.

  • cashRebel May 10, 2013

    I think most folks don’t understand that your asset allocation matters and keeping expenses low matter way more than your exact portfolio. Nice post!

  • Matt @ momanddadmoney May 10, 2013

    Thanks Nick! I’m glad you think it’s helpful.

  • Matt @ momanddadmoney May 10, 2013

    Thanks! It’s so simple that I think a lot of people don’t trust it. But it keeps proving true over and over again.

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