When investing, focus on what really matters

Investment

This post original appeared as an episode in our Financial Autonomy podcast.

 

I remember reading once the advice of someone who had achieved success in their field. Their key observation was, “in life, you will occasionally be faced with times where you have to make a choice. One path will be easy, and the other harder. I’ve been successful because whenever I faced those choices, I chose the harder path”.

Now I think there is great wisdom in these words in the broad journey of your life, but when it comes to investment success, they are plain stupid.

When investing, we want the simplest, most likely to succeed option that there is. And that means focusing on what really matters.

There’s a great analogy made by Brian Portnoy (who I interviewed back in episode 64), in his book the Geometry of Wealth. He’s at an airport and there’s a food court. He’s hungry, but there’s so many options – lots of different restaurants, and each with many different items to choose from. Burgers, Sushi, Chinese, and pizza.

He could look through the menu’s of each establishment until he finds the dish that makes his mouth water. But instead, he narrows his choices. He likes Mexican food. So he heads to the Mexican restaurant and orders a nice pulled pork burrito with extra salsa.

The most important decision for him to make is the type of cuisine he wants. Once he’s made that decision, there’s not that much difference between a pulled pork burrito, or a beef burrito. If he gets the choice of restaurant right, his chances of eating a meal that makes him happy are pretty high.

In the investment universe, the equivalent of getting the restaurant right is your asset allocation. Do you want to be 50% growth assets, such as shares and property, and 50% defensives like cash and bonds? Or would a 90/10 split be more to your taste?

The centrality of asset allocation to investment success was highlighted originally in research done back in 1986. It stoked much debate, and so in 2017 it was substantially re-worked and tested with this revised work largely confirming the original findings.

The original research only looked at US data, but the more recent re-work sourced data from Canada, the UK, Australia, and Japan, in addition to the US. Interestingly the findings were very consistent across all these markets.

They studied Balanced funds and worked with 25 years worth of data – from 1990 to 2015. They found that around 90% of the explanation of variation in performance between one fund and the next was the asset allocation chosen.

So let’s get clear on what is meant by asset allocation. I think of it as two steps. First, what is your split between growth and defensive assets, and then within each of these, what is your split across the options in each.

The 2017 research solved the first question, the growth to defensive split, by looking at Balanced Funds, which if they are true to label (disappointingly few in Australia are), should be a 50/50 split between each.

The right split for you will be determined by factors like your investment time frame, tolerance for volatility, and broader long term investment goals.

The next decision is the appropriate proportion to each asset class. So if you have decided that a Balanced, 50/50 mix is the right level of risk and reward trade-off for you, then of the 50% that is to go to growth assets, how much will you allocate to Australian shares, how much to global shares, and how much to property?

When it comes to focusing your attention on what matters, these decisions are where your energy should be directed.

The next level down, having determined the asset allocation, is should you engage Active fund managers who research and trade stocks regularly, or should you instead simply buy the market via an index fund. The Index fund approach is also known as passive investment, and I talked about this back in episode 58.

Index funds make no effort to pick winners or try to out-smart the market. They simply provide the market return at the lowest cost.

The key take out from episode 58 was:

“63% of Australian active funds and 84% of US active funds fail to beat the benchmark after fees. So is that a bet worth taking?”

The 2017 research on Balanced Funds found that in the US, of 709 funds tested, only 28 delivered excess returns, while 264 provided statistically significant underperformance. Not only that, but the winners delivered on average an extra 2.5% of return, but the losers detracted 3.1%.

So to summarise:

1. What matters with regards you enjoying investment success is getting the asset allocation right.

2. Once you’ve determined that, the best chance of achieving an outcome in-line with expectations, is to engage low cost index funds to invest at least the bulk of your savings.

 

 

 

Important Information:

This information is of a general nature only and has been prepared without taking into account your particular financial needs, circumstances and objectives. While every effort has been made to ensure the accuracy of the information, it is not guaranteed. You should obtain professional advice before acting on the information contained in this publication.

 

The global case for strategic asset allocation and an examination of home bias – Scott, Balsamo, McShane, Tasopoulos – 2017

Determinants of Portfolio Performance – Brinson, Hood, Beebower