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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.
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.
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