Investors today are all looking for ways to earn higher returns. Here are some proven tips to help you improve your returns and possibly avoid some costly investing mistakes. For example, should you choose stocks or bonds or both? Should you invest in small or large companies? Should you choose an active or passive investment strategy? What is rebalancing? Read on to glean some investor ideas that stand the test of time.
1. Bond stocks
Although stocks carry higher risk than bonds, a manageable combination of the two in a portfolio can provide an attractive return with low volatility.
For example, over the investment period from 1926 (when the first tracking data was available) to 2010, the S&P 500 Index (500 large-cap US stocks) achieved an average gross annual return of 9.7 %, while long-term US government bonds averaged 5.6% for the same period.
If you then consider that the consumer price index (CPI – a standard measure of inflation) for the period was 3%, this brought the adjusted real return down to 6.9% for equities and 2 .5% for bonds. Inflation can erode purchasing power and returns, but investing in stocks can help improve returns, making investing a rewarding endeavor.
Average annual returns from 1926 to 2010.
Image by Sabrina Jiang © Investopedia 2020
2. Small and large companies
The performance histories of US companies (since 1926) and international companies (since 1970) show that small-cap companies have outperformed large-cap companies in both US and international markets.
Small businesses present a higher risk than large businesses over time because they are less established. They are candidates for riskier loans for banks, have smaller operations, fewer employees, less inventory and, generally, minimal track records. However, an investment portfolio that favors small and medium-sized companies over large companies has consistently provided higher returns than a portfolio that favors large-cap stocks.
Small US companies have outperformed large US companies with an average return of around 2% per year from 1926 to 2017. Using the same small cap theory, small international companies outperformed large international companies by an average of 5.8 per year over the same period. The chart below shows the average annual index returns for large and small companies from 1926 to 2010, and this trend has not changed from 2010 to 2018, according to US News.
Average annual returns from 1926 to 2010 (US stock indices), from 1970 to 2010 (international stock indices).
Image by Sabrina Jiang © Investopedia 2020
3. Manage your expenses
How you invest your portfolio will have a direct impact on the cost of your investments and the net return on investment that goes into your pocket. The two main investment methods are active management or passive management. Active management has significantly higher costs than passive management. It is typical for the difference in expenses between active and passive management to be at least 1% per year.
Active management tends to be much more expensive than passive management because it requires the knowledge of top research analysts, technicians and economists who are all looking for the next best investment idea for a portfolio. Because active managers have to pay the costs of marketing and selling the funds, they typically attach an annual 12b-1 mutual fund marketing or distribution fee and sales fee to their investments so that brokers of Wall Street are selling their funds.
Passive management is used to minimize investment costs and avoid the negative effects of not predicting future market movements. Index funds use this approach as a means of owning the entire stock market versus market timing and stock picking. Sophisticated investors and academic professionals understand that most active managers fail to beat their respective benchmarks consistently over time. So why incur additional costs when passive management is generally three times cheaper?
Examples:
- A passively managed $1,000,000 portfolio with an expense ratio of 0.40% will cost $4,000 per year for investments.
- An actively managed $1,000,000 portfolio with an expense ratio of 1.20% will cost $12,000 per year for investments.
4. Value or Growth Companies
Since index tracking became available, value companies have outperformed growth companies in the US and international markets. Academic finance professionals who have studied both value and growth firms for decades have commonly referred to this as the “value effect.” A portfolio that favors value companies over growth companies has always provided higher investment returns.
Growth stocks tend to have high stock prices relative to their underlying accounting measures, and they are considered healthy, fast-growing companies that generally care little about dividend payouts. Value companies, on the other hand, have low stock prices relative to their underlying accounting measures such as book value, sales, and earnings.
These companies are struggling and may have weak earnings growth and poor future prospects. Many value companies will offer an annual dividend payout to investors, which can add to the investor’s gross return. It helps if the stock price has a slow appreciation for the given year. The irony is that these struggling value companies have significantly outperformed their healthy growth counterparts over long periods of time, as the chart below illustrates.
Average annual returns from 1975 to 2010.
Image by Sabrina Jiang © Investopedia 2020
5. Diversification
Asset allocation and diversification involves adding multiple asset classes of a different nature (small US stocks, international stocks, REITs, commodities, global bonds) to a portfolio with an appropriate percentage allocation to each class. Since asset classes have different correlations with each other, an effective mix can significantly reduce overall portfolio risk and improve expected return. Commodities (such as wheat, oil, silver) are known to have a low correlation with stocks; thus, they can complement a portfolio by reducing overall portfolio risk and improving expected returns.
“The Lost Decade” became a common nickname for the stock market period between 2000 and 2010, as the S&P 500 Index generated a meager average annual return of 0.40%. However, a diversified portfolio with different asset classes would have had significantly different results.
6. Rebalancing
Over time, a portfolio will drift away from its original asset class percentages and should be brought back in line with goals. A 50/50 combination of stocks and bonds could easily become a 60/40 combination of stocks and bonds after a successful stock market rally. Adjusting the portfolio to its original allocation is called rebalancing.
Rebalancing can be done in three ways:
- Added new cash to the underweight portion of the portfolio.
- Sell part of the overweight coin and add it to the underweight class.
- Take withdrawals from the overweight asset class.
Rebalancing is a smart, efficient and automatic way to buy low and sell high without the risk of emotions affecting investment decisions. Rebalancing can improve portfolio performance and bring a portfolio back to your original level of risk tolerance.
The essential
Despite the complexity of portfolio investing over the past few decades, some simple tools have proven over time to improve investment results. The implementation of tools such as the value and size effect as well as superior asset allocation could add an expected return premium of up to 3% to 5% per year to the annual return of a investor. Investors also need to keep a close eye on portfolio expenses, because reducing these costs adds more to their return instead of fattening the portfolios of investment managers on Wall Street.