What Determines Your Investment Performance?

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investment growth

When it comes to investing, investors are primarily concerned with one thing: making money, otherwise known as their investment performance. This is understandable since your performance is going to determine whether or not you meet your long-term goals.

When choosing an investment, most of us do one of the following:

  • We see an ad for a mutual fund/ETF boasting about last year’s return and we invest in it, thinking it will do the same again.
  • We constantly hear about a particular stock from the news/friends/insert person here and buy it because everyone is talking about it.
  • Some combination of the above.

In most cases, over the long-term, following the tactics above results in failure. In the past, I was guilty of looking at last year’s performance and investing in a mutual fund. It was a tech fund back in 2000. I lost pretty much the entire investment. I was also guilty of hearing about a stock from friends and investing in it too. I bought shares of MCI Worldcom and watched it jump $4 almost daily for about a week when talks were taking place about Worldcom and Sprint merging. The merger never happened. The only thing that did happen was that Worldcom was using fuzzy math and “cooking the books”. A few years later it ended up going out of business. I lost everything in that one too.

If the tactics outlined above don’t relate to investment performance, then what does?

A Study of Investment Performance

A study was conducted years ago by Financial Analysts Journal regarding what determines investment performance. The results were very interesting. The study was conducted over a ten year period (which included both good and bad market years) consisting of 91 large corporate plans. The study found that investment performance could be tied to one of three things:

  • Asset Class Selection (Large Cap vs. Small Cap; Domestic vs. International; etc.)
  • Security Selection (GE vs. Microsoft vs. Apple, etc.)
  • Market Timing

In the graph below, I’ve highlighted how much each of these weighed in determining investment performance.

Investment Performance

As you can see, 94% of investment performance was determined by asset class selection. Just four percent was a result of individual security selection and two percent came from market timing. What does this mean? Well first, it shows that when I lost money by using the techniques I pointed out above I was part of the majority – I was trying to time the market. Most people don’t make money by picking an investment based on last year’s investment performance or the stock that is in the news every day.

Second, it shows that the most important thing you can do to get the best investment performance possible is to pick the right asset classes.

The bad thing about picking the right asset classes though is that you won’t know which asset class is the best one to be in any given year to maximize performance. The only thing you can do is to diversify. Pick a good asset allocation mix and let the chips fall. This might sound boring to some, just pick a good asset allocation and let it ride, but that is what investing is all about. It’s not buying and selling all of the time, as Wall Street would like you to believe. It’s about picking a good allocation and then sticking to it over the long-term.

How Do You Choose a Good Asset Allocation?

To pick an asset allocation, you first need to understand risk tolerance. From there, you can construct a portfolio consisting of equities and fixed income based on your suggested allocation. I highly recommend, Live It Up Without Outliving Your Money by Paul Merriman. It’s an easy read and he gives you low cost sample portfolios from various mutual fund companies including Vanguard, Fidelity and Schwab.

One Last Point

Some of you might look back on the chart above and see that 6% of your investment performance is determined by market timing and security selection. Before you claim that this investment strategy can work, note that in the study, the impact that they had on the portfolio as a whole in determining performance was negative. The average plan actually lost 1% per year because of these two strategies. Put another way, the investment performance of the plans could have been higher by 1% per year had market timing and security selection not been used.

Don’t try to out think Wall Street or investing. It’s not that complicated. We tend to make it much more complicated than it really is. As seen above, the best predictor of having good investment performance is to pick a well-diversified portfolio that you stick with for the long-term.

Author bio: Jon writes for MoneySmartGuides, a personal finance blog that helps educate people on personal finance so that they can reach their financial dreams. He focuses mainly on investing and paying off debt since those are the two of the most challenging personal finance topics we face.

Image courtesy of digitalart / FreeDigitalPhotos.net

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19 Comments... Read them below or add one of your own
  • Alexa Mason August 14, 2013

    When I get ready to invest I will keep it simple. Which that shouldn’t be too much longer. I don’t know enough about the stock market to try to “beat it” I’ll be happy with a simple, consistent approach.

    • MoneySmartGuides August 14, 2013

      Keep that mindset Alexa. Just pick a few low cost mutual funds that will get you diversified and stay invested over the long-term, no matter how bad the media makes times out to be. In fact, those are the times you should be pouring more into your finds.

  • cashRebel August 14, 2013

    Great graph! I think that illustrates your point really well. I know w this from all the investing books I’ve read, but my mind sometimes still likes to think that it’d be able to pick stocks. Great reminder!

    • MoneySmartGuides August 14, 2013

      If you do invest in stocks, just make sure you do your homework first. There is a lot of research that goes into picking healthy companies and more work in staying with new developments.

      • Marissa August 14, 2013

        I agree. It’s best to do some research first before taking your first step.

  • Andrew August 14, 2013

    That’s an interesting study and that graph is an eye-opener which really drives home your point, The majority of my IRA is in Vanguard Target retirement funds but like cashrebel says…sometimes I like to think I’d be able to pick funds/stocks that will do better. I keep that portion of my portfolio small cause I’m probably wrong about that.

    • MoneySmartGuides August 14, 2013

      Many people think they know where the market is headed. They don’t. They might get lucky no and then, but over time, they can’t predict the market.

  • Pat at FeelingFinancial August 14, 2013

    That’s a good study, thanks. If I never own another individual stock in my life, I think I’m OK with that.

    • MoneySmartGuides August 14, 2013

      There is no need to own individual stocks. I have some, but they are in my “play” account where I’m OK if I lose the money. I just don’t have the time to stay on top of them all of the time.

  • John S @ Frugal Rules August 14, 2013

    “Don’t try to out think Wall Street or investing.” I could not agree more Jon. Sadly, too many investors make investing too difficult on themselves or simply don’t follow things they should. Some snicker at diversification, but it really does help when it comes to investing.

    • MoneySmartGuides August 14, 2013

      I show the benefits of diversification on my blog. Too many people make investing so complicated, it’s no wonder why they fail.

  • Done by Forty August 14, 2013

    That pie chart is awesome: it provides visualization about how little market timing should matter. And like you noted, the net effect was negative.

    I’ll pick up that book, as we landed on Bernstein’s Simpleton’s Portfolio a bit by chance: it was at the beginning of the Intelligent Asset Allocator and the simplicity of it sounded pretty good. So, that was that. 🙂

    Maybe a more thoughtful approach is in order. Thanks for the good read!

    • MoneySmartGuides August 14, 2013

      The book is an easy read…I got through it in one night. I especially like that the author builds portfolio’s for you based on funds anyone can invest in.

  • Scott W August 14, 2013

    I made most of the typical mistakes when I first started having an amount worth investing. (trying to pick stocks, too aggressive, market timing)
    Stock broker talked me into about 4k worth of Motorola at $36. Then it plunged to $24 so I bought more because of course it was due to go up. I sold everything at about $18.
    The good news is that I learned some valuable lessons with the small amount of money that I had at the time and I believe I will avoid them now that I have an amount worth worrying about.
    Mutual funds no individual stocks, try to stay the course when market goes on roller coaster and appropriate asset allocation.

    • Matt @ momanddadmoney August 15, 2013

      Like you said Scott, it sounds like you were able to learn some valuable lessons with a relatively small amount of money. That puts you in a much better position than most. Staying a consistent course through the ups and downs is one of the most powerful tools you have as an investor.

  • Edward - Entry Level Dilemma August 14, 2013

    When we got married, I took a look at my wife’s 401(k) because she was complaining that she lost over half of it’s value in the recession. It’s actually still not where it was at it’s high. But it turned out she was entirely invested in company stock, so I diversified. After looking at the annual report yesterday, I’m kind of kicking myself, because that stock gained 52% over the last year!

    • Matt @ momanddadmoney August 15, 2013

      Even when you do the right thing, sometimes it comes back to bite you in the ass. I definitely understand the feeling, but getting out of company stock was definitely the right move.

  • DC @ Young Adult Money August 15, 2013

    Wow, that is one heck of a pie chart! I don’t actively manage my investments that much. I just have a set allocation in my 401k and contribute money each paycheck. I will have to double check the allocation, though, to make sure I’m not too heavy in any one area.

    • Matt @ momanddadmoney August 15, 2013

      Rebalancing is definitely an important part of a long-term strategy. Regular market movements can get you pretty out of whack if you go too long without paying attention.

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