Successful investing hinges on many factors. Some can’t be controlled – the returns of the markets, for example. But others can be. Vanguard believes that following these four principles will allow you to focus on the factors within your control, which can be an effective way to achieve long-term results.

Investment goals

Create clear, appropriate investment goals.

We believe that investors should set measurable and attainable investment goals and develop plans for reaching those goals. Investors with multiple goals (e.g. retirement planning and saving for a child’s education) should have a separate plan for each. Finally, they should evaluate their plans on a regular, ongoing basis.

Without a plan, investors commonly construct their portfolios from the bottom up, paying more attention to choosing and buying investment products than to the process of achieving their goals. Investors without a plan often construct their portfolios by evaluating the merits of each investment individually. If the evaluation is positive, they add the investment to their portfolio, often without considering whether it fits. This process can lead to a mismatch between the portfolio and its objectives. Common, avoidable mistakes include performance chasing and market timing. Figure 1 provides an example of the framework for an investment plan.

Figure 1. Example of a basic framework for an investment plan1

Objectives Save $1,000,000 for retirement, adjusted for inflation.
Moderate tolerance for volatility and loss; no tolerance for non-traditional risks1
Constraints Current portfolio value: $50,000.
30 years horizon.
Monthly net income of $4,000; monthly expenses of $3,000.
Saving or spending target Able to contribute $5,000 annually.
Expectation of $500 increase per year.
Asset allocation target 70% equity; 30% fixed income.
Allocate to global as appropriate.
Sub asset Market proportional within asset classes.
Passive/active Passive investment approach using index funds and ETFs where appropriate.
Rebalancing methodology Rebalance annually.
Monitoring and evaluation Periodically evaluate current portfolio value relative to savings targets, return expectations and long-term objective.
Adjust as needed.

This example is completely hypothetical. It does not represent any real investor and should not be taken as a guide. Depending on an actual investor’s circumstances, such a plan or investment policy statement could be expanded or consolidated. For example, many financial advisers or institutions may find value in outlining the investment strategy; i.e. specifying whether tactical asset allocation will be employed, whether actively or passively managed funds will be used, and the like.
Source: Vanguard.

1 There are many definitions of risk, including the traditional definitions (volatility, loss, and shortfall) and some non-traditional ones (liquidity, manager, and leverage). Investment professionals commonly define risk as the volatility inherent to a given asset or investment strategy. For more on the various risk metrics used in the financial industry, see Ambrosio (2007).

Some investors may be influenced by the performance of the broad stock market, increasing stock exposure when stocks are performing well and reducing it when they’re not. Such behaviour is evidenced by investor cash flows, which tend to reflect emotional responses rather than more rational approaches. A sound plan should help investors avoid this type of behaviour and focus instead on asset allocation, diversification, rebalancing and saving and spending rates.

Vanguard believes that investors should spend more time on developing plans than on evaluating every new idea touted in the media. This simple reallocation of time can go a long way towards meeting investment objectives.

Asset allocation

Develop a suitable asset allocation using broadly diversified funds.

We believe that a successful investment strategy starts with an asset allocation suitable for its objective. Investors should establish an asset allocation using reasonable expectations for risk and returns. The use of diversified investments helps to limit exposure to unnecessary risks.

When developing their portfolios, investors should select the combination of equities, bonds and other investment types offering the best chance for success. This top-down asset allocation decision is among the most important factors in determining whether investors meet their objectives.

But why not simply aim to reduce the potential for loss and finance all goals through low-risk investments such as government-issued bonds? Because the decision to invest in more stable but lower-returning assets can expose a portfolio to other, longer-term risks, including the risk that an investment will fail to deliver the returns necessary to finance long-term goals. To reach their goals, investors might need to increase their saving rate  – or they might need to decrease their future spending.

Figure 2 shows the influence that asset allocation can have on portfolio returns.

Average returns for various equities/bond/cash allocations, 1998-2016

This chart shows the simulated past performance of the asset mix and time frame chosen on the sliding scales above. This is based on the actual past performance of indices representing each asset. Indices used for AU equities, AU bonds, and AU cash are S&P/ASX300 Total Return Index, Bloomberg AusBond Comp 0+Y Total Return AUD Index, and Bloomberg AusBond Bank Bill Total Return AUD Index, respectively.

Diversification is a powerful strategy for managing traditional risks. Within an asset class (such as equities or bonds), diversification reduces a portfolio’s exposure to risks associated with a particular company or sector. Across asset classes, it reduces a portfolio’s exposure to the risks of any one class. It cannot eliminate the risk of loss, but it can help to protect against unnecessarily large losses resulting from the underperformance of one portion of the portfolio. Undiversified portfolios also have greater potential to suffer catastrophic losses.

Minimise cost

Minimise cost.

Investors can’t control the markets, but they can control how much they are willing to pay. Every dollar that investors pay for management fees or trading commissions is a dollar less of potential return. In addition, our experience has been that, historically, lower-cost investments have tended to outperform higher-cost alternatives in the long term.

Investors can improve their investment returns in two ways. First, they can invest in winning managers or strategies, but this can be difficult to do. Second, they can control the cost of investing. Low-cost funds simply take less of a bite out of returns than higher-cost alternatives do.

The tool in figure 3 shows the importance of cost on portfolio returns.

Figure 3. The long-term impact of investment costs on portfolio balances

Assuming a starting balance of $10,000

These results are hypothetical and do not represent any particular investment.

Indexed investments can give investors the opportunity to outperform higher-cost actively managed investments because index funds generally operate with lower costs (but because index funds track a benchmark, they are unlikely to outperform the market in any event). The higher expenses for actively managed funds often result from the costs associated with trying to outperform the market (e.g. the research and transaction costs involved in buying or selling the underlying securities).

Maintain Perspective

Maintain perspective and long-term discipline.

Investing can evoke emotion that could disrupt the plans of even the most sophisticated investors. Some make rash decisions based on market volatility, but investors can counter that emotion with discipline and a long-term perspective. They should adopt a systematic approach to investing based on the principles of asset allocation and diversification—and then stick to that plan.

Rebalancing brings the portfolio back in line with the asset allocation established to meet the investor’s objectives. We believe that investors should check their asset allocation once or twice a year.

When equities are performing poorly, investors may naturally be reluctant to sell, for example, bond funds that are performing well and buy more equity funds. But the worst market declines can lead to the best buying opportunities. Investors who don’t rebalance their portfolios during these difficult times may be jeopardising their long-term investment goals.

Figure 4 shows the impact of fleeing an asset allocation during a bear market for equities. In this example, the investor moves out of equities on February 28, 2009 to avoid further loses. While both the 100% fixed income and cash portfolios experienced less volatility, the investor who chose to stay with the original asset allocation recovered most completely from the 2009 setback to earn a superior return.

Figure 4. The importance of maintaining discipline: Reacting to market volatility can jeopardise return

What if the “drifting” investor fled from equities after the 2008 plunge and invested 100% in either cash or fixed income?

Figure 4

Notes: 1 Oct 2007 represents the EQ peak of the period, and has been indexed to 100. Assumes that all dividends and income are reinvested in the respective index. ‘Equities’ are made up of 35% Aus Equity and 35% Intl Equity, which are rebalanced back to the 35/35% split at month end. Aus Equity = S&P/ASX 300 Index Total Return, Intl Equity = MSCI World ex-Aus in A$ Total Return, Fixed Income = Barclays Global Agg Hedged in AUD, Aus Cash = Bloomberg AusBond Bank Bill Index. Past performance is not an indicator of future performance.

Source: Vanguard calculations using data sourced from DataStream through January 2016.

To meet any investment objective, an investor must rely on the interaction of the portfolio’s initial assets, the saving or spending rate over time, asset allocation and market returns. Because the future market return is unknowable and uncontrollable, investors should focus on those factors within their control.