Investing principles for an uncertain world

Posted by on March 12, 2013 @ 10:45 am in investing

I recently traveled to Vanguard’s international offices, and no matter where I found myself on the globe, the topic of market and economic uncertainty was a constant theme.

For example, China’s transition from an investment-driven economy to a consumer-based model is still in its early stages. In Europe, the worst seems to be behind us, but questions remain with respect to the political will and long-term competitiveness of some members of the European Union. At home, the U.S. government continues to drag its feet on approving a real solution to deal with our daunting national debt.

On the other side of the coin, stock market returns have been robust, up 156% in the United States since the depths of the global financial crisis in March 2009. And, in the first two months of 2013, the S&P 500 Index gained 6.6%, while the Dow Jones Industrial Average touched all-time highs in March.  Investor interest in stocks has undoubtedly been rekindled.

This dichotomy between economic conditions and financial market returns are likely confusing to investors, if not taxing to their confidence. As such, it may be an apt time to revisit the four simple and straightforward principles that we believe lead to long-term investment success.

Let me give you the Cliffs Notes of Vanguard’s Principles for Investment Success; for a full read, see our white paper.

First, create clear, appropriate investment goals. I certainly had a carefully planned itinerary for my travels around the globe. The same holds true in investing—creating a sound plan is the first step on the journey to investment success. Start with clearly defined, long-term, measurable, and reasonable goals. And you may have multiple goals, including investing for retirement or socking away money for a child’s college education.

With your goals as your jumping-off point, develop a suitable asset allocation using broadly diversified funds. A diversified portfolio of stock, bonds, and other investments is the primary determinant of a portfolio’s returns and variability of returns. This has been well documented in theory and in practice. Vanguard research published in 2012 confirmed the seminal 1986 study by Brinson, Hood, and Beebower, which demonstrated that the asset allocation decision was responsible for 88% of a diversified portfolio’s return patterns over time.

Percentage of a portfolio's movements over time explained by 1. Security selection and market timing and 2. Asset Allocation

Note: Calculations are based on monthly returns for 518 U.s. balanced funds from January 1962 through December 2011. For details of the methodology, see the Vanguard research paper, The Global Case for Strategic Asset Allocation (Wallick et al., 2012). Source: Vanguard calculations using data from Morningstar.

As we say in our paper, markets are unpredictable, and costs are forever. Our third principle is critical: minimize cost. The math is inarguable: Higher costs can significantly erode a portfolio’s growth over time, as shown in the accompanying table. Costs not only include the expenses related to purchasing and owning investments but also the taxes. That’s why allocating investments among taxable and tax-advantaged accounts in a thoughtful manner is important.

A comparison of the impacts of investment costs on a portfolio.

Note: The portfolio balances shown are hypothetical and do not reflect any particular investment. The examples assume a starting balance of $100,000 and a yearly return of 6%, which is reinvested. The final account balances do not reflect any taxes or penalties that might be due upon distribution. Source: Vanguard

 

Finally, the three principles that I’ve discussed so far are moot if you fail to maintain perspective and long-term discipline. The continual rise and fall of the financial markets, accompanied by the din of daily commentary and predictions from so-called experts may lead some investors to make impulsive decisions or, conversely, fall prey to inertia. In addition, research has shown that some of the most significant derailers are behavioral: The failure to rebalance, the allure of market-timing, and the temptation to chase performance. Perspective and discipline can help you remain committed to your long-term investment programs through periods of market uncertainty.

Vanguard has been seeking to lower the cost and complexity of investing for over 35 years.  We hope that these simple, time-tested principles will help put you on the right track to reaching your investment goals.

Note: All investing is subject to risk, including possible loss of principal. Bonds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. Diversification does not ensure a profit or protect against a loss.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.