Three secrets to better investment outcomes

What makes for a sound investment strategy? What makes for a good investor? Why is it that some people achieve better investment outcomes than others? 

The truth is, the most successful investors know that the real secret to their success lies in a disciplined approach and avoiding quick-fix solutions that fail to stand the test of time.

Sure, there is always someone that gets it right in the short term, but investing isn’t about posting a quarterly rate of return. Instead, it’s about achieving an appropriate return with the right level of risk for your strategy and the life you want to live.

Here are the three secrets that good investors know that lead to better investment outcomes.

Secret #1 - The right approach starts with the right mindset

“The investor’s chief problem — and his worst enemy — is likely to be himself.

In the end, how your investments behave is much less important than how you behave.”

Benjamin Graham

Picking the winners, timing the market, and avoiding downturns and recessions sounds pretty good. Unfortunately, these strategies don’t work to your advantage consistently over time. In fact, 80% to 90% or more of actively managed investments underperform their benchmarks. Here’s what that can mean for your investment returns over time.

Your behavior will determine your investment outcomes, whether you react to market turbulence or remain disciplined in your plan. If you’re trying to outperform the market on your own or working with a money manager who’s more concerned with their commissions than your financial health and well-being, you’re playing in risky territory.

Every year, DALBAR* releases a study that compares the returns of the market – they use the S&P 500 – compared to everyday investors – which they call “average equity (or stock) fund investors.” What they find is that the average investor underperforms. The difference between market returns and average investor returns is called “the behavior gap.” The chart below shows this gap over various time periods.

Summary of Returns for the Period Ending 12/31/2020**

Slight differences in your returns relative to the markets may not seem like a big deal day-to-day. But over decades, which is how long investing time horizons span, they can have a devastating impact on your money.

Here’s an example:

Suppose you invested $100,000 today and never added any money to the account. After 30 years, here’s how much money you would have at different rates of return:

At 6.24% (the “average investor” return): $614,669

At 10.70% (the S&P 500 return): $2,110,710

Does not include the impact of fees or taxes on investment returns.

The difference is staggering and life-changing, to say the least. The best investors know that better investment outcomes don’t come from market timing. Instead, it’s about proper diversification to help you manage risk while achieving an appropriate return.

Secret #2 - Managing risk and return through diversification

“Diversification is the only free lunch in finance.”

Harry Markowitz (Nobel Prize Winner)

You’ve probably heard the saying that you shouldn’t put all of your eggs in one basket, which is where diversification comes into play. It’s a critical element of any investment strategy as it can help you manage risk in your overall portfolio. Here’s how diversification works.

In its simplest form, diversification is about investing in a broad assortment of stocks and bonds based on how much risk is suitable for you. Investing in just one company can lead to nice returns but also expose you to catastrophic losses. Broadly investing across hundreds if not thousands of stocks and bonds reduces the overall risk in your portfolio while still helping you achieve an appropriate return.

The lesser-known benefit of diversification is that, if done well, it can help you lower your overall risk without sacrificing your returns. The trick is that you can’t just own a handful of different investments. You have to understand how those investments behave with each other during different market environments. This is why Harry Markowitz called diversification a “free lunch.” With the right mix of investments across asset classes, you can lower your risk without sacrificing return.

The chart below is a bit technical, but it’s an important concept to understand. The Sharpe ratio in the right-hand column is a measure of return per unit of risk (the higher, the better). Think of it this way: when you take on more risk in an investment, you want a greater return from it, but not all investments work that way. However, you can combine different assets – in this example, US and international stocks – to achieve a better return for a given level of risk – also called a higher risk-adjusted return. And that’s the key. It’s not just about a return. It’s about minimizing your risk for a given level of return or maximizing your return for a given level of risk.

Source: Markowitz, 1952 (https://www.math.hkust.edu.hk/~maykwok/courses/ma362/07F/markowitz_JF.pdf)

Diversification is not a one-time thing. It requires oversight over time to manage risk as you get closer to retirement. That being said, it’s also important to review your investments periodically to rebalance, manage taxes, and make sure you are on track. The only way to do this is to have a plan.

Secret #3 - Your financial plan is your key to better outcomes

“Planning is bringing the future into the present so that you can do something about it now.”

Alan Lakein

The biggest mistake that most people make is that they invest without a plan. But good investors know that their financial plan is the very foundation of a successful investment strategy. Here’s why.

Your life is ever-changing and dynamic, and you need a strategy to navigate every moment with greater clarity and confidence. An ongoing and evolving plan helps you determine not just how to make smart decisions with your money today but how to balance everyday life with long-term investing. It will help you decide how much to save, the types of accounts to invest in, how to minimize fees and lower your taxes, the appropriate level of diversification to manage risk, and so much more.

The point is that your plan gives you a course to follow through good times and bad. It helps you remain disciplined and avoid reacting to market events which can be very costly. The best investors know that during periods of market exuberance and turbulence, there is one thing that really matters: focusing on what you can control.

It’s not how the market behaves that will determine your success. It’s how you behave that will determine your investment outcomes. Your plan, which evolves with you through every stage of life, is essential to creating clear direction in your investment strategy and staying focused on the things that drive your returns.

Yes, returns matter, but they are far less important than having a plan for your life and a strategy for your investments that can put you in control of the life you want to live. 

A financial plan is your key to better investment outcomes. Learn how a CFP® Professional at Facet can help you create a personalized plan and investment strategy that positions you for the best investment outcomes.

_{*Average Investor as determined by Dalbar.}

_{** Source: "Quantitative Analysis of Investor Behavior (QAIB), 2021," DALBAR, Inc. www.dalbar.com.}