The adoption of a great idea

Posted by and on May 22, 2013 @ 3:40 pm in Economy & markets

Joe Davis and Andy Clarke collaborated on this post, the result of a conversation about research that Vanguards Investment Strategy Group has conducted on the adoption and economic impact of “great ideas.”

 

Andy Clarke

Do you remember when you first encountered the World Wide Web? I do. It was 1993, in an office cubicle in Chicago. A colleague sat in front of her PC, scrolling through a screen of text and images. She clicked on links, opening new pages of text and images. To me, admittedly a late adopter of most technologies, it looked like magic.

When she explained what it was—a webpage for a local catering service—I had one thought: “That’s a great idea.”

I remembered this moment recently as Vanguard Chief Economist Joe Davis and I talked about his team’s research on the adoption rates of great ideas. Some ideas, such as the internet, were adopted at lightning speed. Others caught on more slowly. In the 1880s, Thomas Edison built a power plant and electrical distribution system in New York City. Not until the 1940s, however, did electric power reach 80% of U.S. households. Adoption of the automobile took even longer.

What’s the next great idea? I’m intrigued by the possibility that it’s something we’re enthusiastic about here at Vanguard: the broadly diversified, low-cost portfolio.

Market penetration rates

adoption-great-idea

Source: Adapted from Visualizing Economics and The New York Times. Vanguard calculated the growth in the low-cost portfolio based on data from Morningstar, Inc. The calculation represents the percentage of U.S. mutual fund and ETF assets under management with annual expense ratios of less than 25 basis points.

 

Joe Davis

Much like electricity, refrigeration, and other great ideas, the broadly diversified, low-cost portfolio has the potential to raise our standard of living.

Research has established that the performance of an investment program depends mostly on a few key ideas:

  • Asset allocation is key. A portfolio’s mix of stocks, bonds, and other assets is the primary driver of its long-term returns and the variability of those returns¹
  • Diversification moderates risk. Diversifying within and across asset classes reduces a portfolio’s exposure to the risks associated with a particular company, market segment, or asset class²
  • Higher costs mean lower returns. The lower your costs, the greater your share of an investment’s return. Over time, lower-cost portfolios have tended to outperform their higher-cost counterparts.³

The broadly diversified, low-cost portfolio, whether delivered in a single mutual fund or as a collection of stock and bond funds, capitalizes on all three of these insights. It’s, quite simply, a great idea.

The adoption of great ideas typically follows an “S” curve, starting slowly, then accelerating. Eventually, the great idea becomes commonplace. The adoption of the “broad low-cost portfolio” seems to be following this pattern.

In 1995, according to data provided by Morningstar, mutual funds and ETFs with an expense ratio of less than 25 basis points accounted for only about 5% of industry assets. Let’s call these investors the “early adopters,” Vanguard clients prominent among them. They were the first to recognize the power of the broadly diversified, low-cost portfolio.

By the end of 2012, adoption had accelerated, and portfolios with expense ratios of less than 25 basis points accounted for about 25% of industry assets.⁴ That’s progress, but investors still have a huge opportunity to lower their costs and keep more of their returns. More assets are invested in funds and ETFs with expense ratios of more than 75 basis points than in portfolios with expense ratios of less than 50 basis points.

We’re in the second or third inning of a remarkable shift toward broadly diversified, low-cost portfolios, an idea that has the power to change our lives for the better.

We would like to thank Kyle Morrison, Todd Schlanger, and Yan Zilbering for their significant contributions to this blog post.

¹ Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower, 1986. Determinants of Portfolio Performance. Financial Analysts Journal 42(4): 39–48. [Reprinted in Financial Analysts Journal 51(1): 133–8. (50th Anniversary Issue)]

² Bennyhoff, Donald G., 2009. Did Diversification Let Us Down? Valley Forge, Pa.: The Vanguard Group.

³  Phillips, Christopher B., and Francis M. Kinniry Jr., 2010. Mutual Fund Ratings and Future Performance. Valley Forge, Pa.: The Vanguard Group.

⁴ For additional insight into the adoption of low-cost funds, see Kinniry, Francis M., Donald G. Bennyhoff, and Yan Zilbering, 2013. Costs matter: Are fund investors voting with their feet? Valley Forge, Pa.: The Vanguard Group.

Notes: All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.

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