Every investor wants to know what factors influence the returns on their investment portfolio. This is, after all, a critical component in building one’s retirement nest egg.
These elements are more complex and layered than we may think. Sure, we can cite a handful of considerations that would no doubt play into our returns: the economy, risk, taxes, interest rates, valuations, sentiment, corporate profits. None of these answers are wrong – they’re just not as simple as they seem.
For instance, sentiment may offset valuation in certain situations. Likewise, profit flux could be influenced by price-earnings ratios. In the big picture, all of these cogs are important, but they play off of one another and exist on a sliding scale.
So how do we get our brains around what drives our returns? I’ve compiled a short list of considerations that I think all investors should understand. Read on to see if there is something you’re overlooking (or overemphasizing) in your investment strategy.
1. Asset allocation: Research and history have proven that allocation is more influential in generating returns than pure stock selection. Finding the “just right” ratio of stocks, bonds, real estate investment trusts, alternative investment and cash in your portfolio is an individual process. It depends largely on your age and risk tolerance. I’m a big proponent of the 15/50 Stock Rule, which states that if you believe you have 15 years left on this planet, your portfolio should consist of at least 50% stocks, with the remaining balance in bonds and cash. The goal is to strike a constant balance between risk and reward. As always, it’s smart to talk to a financial professional to get help guiding you if you feel lost in the maze.
2. Costs and expenses: The overall cost of a portfolio, compounded over 20 or 30 years, can add up to a hefty chunk of the returns. With the rise of indexing during the past decade, we see a growing understanding that cost matters more than stock-picking prowess. Of course, you have unavoidable costs, like trading expenses and capital-gains taxes, but it’s good to keep the controllable costs as low as possible.
3. Valuation and lifespan: For the long-term investor, valuations come down to when they start investing and when they start to withdraw during retirement. Folks born in 1948, for example, not only managed to have their peak earning and investing years overlap with multiple bull markets and interest rate drops, but they also lucked out with a market that has tripled in the decade before their retirement age. This is proof that it’s best to start investing as soon as you can and stay invested for the long haul.
4. Starting early: When you begin saving for retirement is something you have complete control over. The sooner you start, the longer compounding can work its magic in your budding portfolio.
5. Security selection: This is merely one element of many and, as we discussed above, it is subject to other factors. Think about the world of active stock-picking mutual funds. The range of outcomes from skill or pure dumb luck is fairly wide-ranging. The net gains attributable to selection, however, can easily be offset by any of the other factors on this list
6. Discipline and emotions: This is a big one. I’ve said it many times: investing is an emotional process. It’s best approached from a place of balance and reason, but our feelings have a way of pushing towards rash decisions. Don’t. Try to remain calm and balanced when working with your portfolio. And remember, unlike some other items on this list, we have complete control over our feelings (or at least how we choose to respond to them.)
7. Humility: Everyone starts off as a novice investor. We all make mistakes. I’ll bet even folks like Warren Buffet and Jack Bogle have made a few. The key here is whether we figure out the things we may be doing wrong and fix those shortcomings. It pays to practice self-awareness. The sooner we learn to learn from our past decisions, the better off our investment portfolios will be.
