The concept of “investing success,” as it often appears in the media, is a tangled web to me. Every time I read about the topic, I can’t help feeling that the author is confusing two very different efforts: investment success and investor success.
This is nuanced but consequential. Too often, investment success is defined by either absolute or relative returns (which is another nuance for another time). And, while I understand why a portfolio manager would focus on higher returns, higher returns shouldn’t be the benchmark for success for the typical investor. Instead, the typical investor should focus on building the wealth they need to fulfill the objectives that matter most to them. Wealth is measured in dollars, not percents.
Sure, higher returns can build wealth faster, but they are not essential to building wealth. Investing is a partnership between an investor and the markets, where an investor provides the capital and the markets provide the prospects for a return on that capital. Understanding this relationship introduces a most important point for building wealth—the power of capital contributions or, more generally, saving. A portfolio’s value can grow through both capital contributions and the return on capital, but only capital contributions can grow wealth reliably. Saving is our contribution to our own investment success and importantly, unlike the investment returns we seek, its benefits are both more certain and within our control.
As illustrated in the figure below, moving from a more conservative asset allocation to a more aggressive one tends to widen the range of expected outcomes. At any asset allocation, higher savings levels result in higher best, worst, and median expected outcomes. What is often overlooked, however, is that higher levels of capital contributions allow investors to improve their expected outcomes not only relative to the same asset allocation, but also to higher risk allocations. For example, the majority of potential outcomes are better with a 6% contribution rate and a moderate risk (50% stock/50% bond) portfolio than a 4% savings rate and an aggressive (80% stock/20% bond) portfolio.
Higher returns are welcomed, but they are a less reliable source of wealth creation. A most extreme version of this scenario played itself out on the national stage with the recent Powerball lottery and its $1 billion-plus jackpot. While the lottery gave a player a chance for a fabulous return on their $2 ticket, probability-wise, a player’s wealth would increase more certainly if they didn’t play the lottery at all (since they’re most likely to lose their whole “investment” in lottery tickets).
Investing involves tradeoffs. An important aspect of the financial planning process is for an investor to define their willingness to forego spending now to improve their prospects for building wealth that can provide for future needs. This is critically important, as a higher savings rate provides a higher probability of investor success, due to the partial shift in responsibility for building wealth from the less-certain returns from risky assets to a more-certain stream of capital contributions. In the end, if an investor is trying to maximize future wealth, a marginally higher savings rate, rather than a substantially higher risk portfolio, is the most likely path to success.
All investing is subject to risk, including the possible loss of the money you invest.
The projections or other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based. The VCMM is a proprietary financial simulation tool developed and maintained by Vanguard’s Investment Strategy Group. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the VCMM is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.