Investing is important. Wait, what? You’ve heard that before? Okay, I’ll admit I’m not exactly breaking new ground when I say that. But there are many different ways to invest, and asking 100 different people about the best way to do it is likely to give you 100 different answers. So while we all know that it’s important, it can be difficult to know exactly where to start.
Today I’m going to explain the benefits of a simple investment strategy and why it’s often the most effective way to reach your long-term financial goals.
The Characteristics A Simple Investment Strategy
A simple investment strategy is one that meets three criteria:
- Low maintenance
- Low cost
- Derives its returns from the markets, not from managers
This is the first item because it’s really the heart of a simple plan. You want your investments to continue working for you with minimal intervention on your part. The less you have to do, the more time you’ll have for other endeavors and the less likely you’ll be to make the behavioral errors that plague so many investors.
At this point, it’s no secret that costs really matter with investing. Morningstar has even found that cost is a better predictor of future mutual fund performance than its own star rating system. The amount you pay for your investments is also one of the few decisions that is directly in your control, which makes it well worth focusing on. Setting up your plan with solid low-cost investments is easy to do and directly improves your bottom line.
Derives Its Returns From The Markets, Not From Managers
Over 90% of your investment returns will be determined by two factors (see a summary of the research here):
- The return of the markets as a whole
- Your exposure to those markets, as determined by your asset allocation
Active management, whether its picking your own stocks or using mutual funds run by managers trying to beat the market, accounts for less than 10% of your return. So it’s just not an efficient use of your time to try and focus on that 10%.
Beyond that, all of the data shows that investors are simply not good at consistently getting better-than market returns, and that includes the professionals (see here). Relying on manager expertise to produce returns is not only unlikely to work, but it requires constant monitoring and evaluation so you can try to switch strategies and/or managers at the right times. That violates our very first tenet of low maintenance.
If you’re following the guidelines above, what you’ll likely come to is an investment strategy focused around a few low-cost index funds that mimic the major markets, including:
- US and international stock markets
- US and international bond markets
- Real estate
There are other potential markets to consider, but these are the major players. Remember, we’re trying to find a strategy that requires less but delivers more, and adding more complexity than this provides diminishing returns.
The Benefits of a Simple Investment Strategy
Now that we know what a simple investment strategy looks like, it’s time to investigate the reasons why we would want one in the first place. After all, simplicity isn’t a goal in and of itself. We all have real financial goals we’re trying to achieve so there have to be some concrete benefits to whatever strategy we implement. Let’s take a look at what a simple investment strategy has to offer.
The primary goal of any investor should be to secure a fair risk-adjusted return. After all, your financial goals are important and you want to be putting your money to work in the most efficient way possible.
This is really where a simple investment strategy shines. The data has long shown that investors trying to beat the market fail to do so more often than not. It’s also shown that the investors who do manage to beat the market over one period are more likely than not to lose over the next period. In other words, simple indexes consistently beat active investors.
But there’s some new research by Rick Ferri and Alex Banke that expands on that data in a powerful way. Among other things, they looked at a portfolio made up of three real broad index funds (US stocks, international stocks, US bonds) compared to similar portfolios made up of actively managed funds. Running multiple trials, they found that the simple index-oriented strategy beat the active strategy over 80% of the time. They also found that as you increased the length of time you held the investments, you increased the advantage for the simple strategy. So investors with a long investment horizon can derive even more benefit.
But wait, there’s more! Not only did the research show that a simple index approach had enormous odds of success, but the magnitude of its successes was greater than the magnitude of its failures. They found that when the simple strategy won, the median outperformance was 1.25%. When it lost, the median underperformance was 0.52%. So not only do you have better odds of winning with the simple strategy, but the upside is significantly greater than the downside.
It Frees Up Time
One of my favorite investing lessons comes from Warren Buffett, courtesy of this article from Tim Ferris. Ferris recounts his experience at the Berkshire Hathaway annual meeting, where he had the opportunity to ask Buffett what he should do with the $1 million he had to invest, given that he made his money outside of the investment world. The response?
Buffett let out a small laugh and began. “I’d put it all in a low-cost index fund that tracks the S&P 500 and get back to work…”
For younger people especially, probably the biggest financial asset you have is your human capital. That is, your ability to earn money over your lifetime. If your goal is wealth generation, it makes sense to focus much of your efforts on increasing your earning power, which will increase the amount you can save and therefore increase your wealth. What does that work require? Time. A simple investment strategy is not only incredibly effective, but it frees up your time to do the things that you’re actually good at that will make you more money. That’s a much faster way to financial freedom than adding unnecessary complexity to your investment plan.
Easier To Understand. Limits Mistakes.
As investors, we are often our own worst enemies. We fall victim to overconfidence, under-confidence, panic, greed, fear, rash decision-making and everything in between. It’s often the case that the actions we take do much more to lower our returns than to increase them.
A simple investment strategy has the benefit of being easy to understand and easy to maintain. Both of these things decrease the amount of ongoing thought and action required of us, which decreases the chances for us to do something dumb. In all seriousness, avoiding the big mistakes that plague so many investors is one of the most powerful things you can do to increase your investment returns. So keep it simple, focus on the things you’re truly good at and enjoy, and let your simple investment plan work its magic.
About The Author
Matt Becker is a proud father and husband and his site Mom and Dad Money is dedicated to helping new parents build financial security for their family and invest for their future. You can also find him on Facebook and Twitter.