There are so many interesting things to debate in investing. The active vs. passive debate has been the subject of more articles than I can count. Although the conclusion that most people should invest passively is clear, there are many nuances to it that continue to be debated every day. And for those people that do decide to be active, there are a variety of decisions that come along with that. For example, whether to invest in value or growth, and which manager to pick within that style. For factor investors, which factor or factors to follow can be another significant decision.
The interest in these types of decisions is very high and so they are all widely covered in the financial press and on blogs like this. We write about many topics on our blog and have written over 3000 posts since 2009, but our article on whether the Price/Book factor is cheap two weeks ago was the most read post we have ever produced by a wide margin. It also generated more back and forth debate than any post we have ever done. Neither of these was due to my amazing writing (although I wish it was). It is more a sign of how much interest there is in these kind of topics.
But there is a problem with focusing on the more detailed decisions in investing: none of them are the decisions that will primarily determine your ultimate success.
Investing success comes down to two major decisions. If you get them right and have the correct expectations, you are likely to meet your goals. If you get them wrong, you are not.
The two decisions are very simple:
- How will you allocate your money among asset classes?
- Will you stay the course during tough times?
Let’s tackle them one at a time.
Decision #1 – What Assets Do You Invest In?
The most important choice you can make in investing is which asset classes you invest in and your allocation among them. This is true for a couple of major reasons. First, in aggregate, asset allocation determines essentially 100% of a portfolio’s return in the long-run, while selection of securities within each asset class has almost no impact. In individual cases, this can obviously not be true, but when all investors are summed up, it is.
To explain why, it is important to understand a basic investing theory. By definition, the total of all managers, both active and passive, will match the return of the asset class they invest in before accounting for fees. Active managers will underperform the passive managers on average by the difference in fees between the two. So on balance, investors will achieve the same return on their equity portfolios as the overall market and bond investors will do the same. As a result, the way to alter long-term returns is to change the allocation between the asset classes, not what you invest in within them.
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