If investing were medicine, would your portfolio make you sick or help you get better? What do I mean? Well, in the medical field much of the protocol that is used in the diagnosis and treatment of various conditions comes from well-researched and academically proven approaches – that also considers a patient’s preferences and the health professional’s expertise. This is known as Evidence-based practice. It is understood that outcomes are never guaranteed as there are things beyond the provider’s control. But if the inputs are designed to give patients in similar circumstances the best result, the patient should have greater confidence in knowing their treatment protocol has been researched and proven effective.
Contrast that approach to going to a doctor with no protocols as once was the case! Back in the days when Bloodletting was considered an appropriate treatment for many ailments. Or a Lobotomy to straighten out someone who was not thinking clearly. While this sounds almost comical today, it is comparable to what many investors (and unfortunately some advisors) do when investing their life’s savings.
Wikipedia defines Evidence-based practice as the idea that occupational practices ought to be based on scientific evidence. While this approach to problem solving started in healthcare, it is used in a lot of different fields now from education, management, and law to public policy – and, yes, even investing! And while the principles and practices change in different industries, one thing that remains consistent is the idea that education and information have the potential to produce better results.
In short, the idea is that the approach being used to manage your investments should be anchored in time-tested principles and not a feeling, whim, premonition, or someone’s ability to predict the future. Here are some examples of principles that can be applied to building your portfolio:
- Diversification reduces risk – owning and loaning to companies of different sizes, in different industries and geographically dispersed reduces certain risks.
- There is a tradeoff between risk and return – stocks offer higher return potential than bonds whereas bonds provide ballast against a financial storm. How much of each will determine the investor’s ultimate ride and level of increase or decrease.
- Small companies offer higher return potential than large companies. Amazon and Apple were once small companies, but many small companies fail to make it, so they have more risk.
- The higher your investment costs, the lower your returns – the cost of your funds is important and may be the best predictor of how a given fund will perform over time.
In addition to understanding the variables that will affect your long-term investment returns, it is good to also know what to expect from your portfolio.
- Since 1926, the US stock market has rewarded investors with average annual returns of around 10%.
- Average return is very different than annual return. Annual returns came within two percentage points of the market’s long-term average of 10% in just six of the past 94 years.
- In any given year, returns have been as high as a 54% gain and as low as a 43% loss.
- Since 1926, annual returns have been positive 69 times and negative 25 times… so on average 7 out of 10 years the market goes up and 3 out of 10 it goes down.
Even though the stock market offers higher return potential than bonds or cash, the average investor earns far less. According to Dalbar, over the most recent 20-year period a balanced 60/40 portfolio would have earned around 5.6% each year. Unfortunately, the average investor earned just 2.5% per year due to jumping in and out of the market. This is because it is nearly impossible to predict what the stock market will do on any given day.
Not following the right investment principles is how many investors hurt themselves and jeopardize their own financial security. Knowing and implementing evidence-based investing practices can provide a solid foundation for investing success. If you need help with how to diversify your investments, knowing what funds or exchange-traded funds (ETFs) to buy, or understanding how much you are paying for your investments get professional help. Just be sure when you do, the advisor is a fiduciary who practices what you have read here. Your portfolio will be glad you did!