Investing Versus Saving
In the pursuit of a comfortable lifestyle and secure retirement, many individuals engage in investing with hopes of achieving significant gains. However, the reality is that saving, particularly in the early stages, is more critical to long-term financial well-being and security than investment performance.
If insufficient savings are accumulated and one manages to outperform the indexes for a brief period, it may result in a Pyrrhic victory, having surmounted one obstacle on a steep and obstacle-laden path. A robust savings rate paves the way, even if it does not generate bragging rights like a high-performing investment.
Choosing Versus Diversifying
It is natural to assume that successful investing entails a series of wise choices. After all, life tends to reward prudent decisions regarding education, family, and career that deliver long-term benefits.
Investing does not penalize prudence – in fact, it rewards it. However, it differs in that the more choices we confront, the more we jeopardize our plans. Difficult investment decisions often arise in times of stress or uncertainty, when we may be prone to impulsivity, panic selling, or buying due to fear of missing out.
Diversification across assets is inherently imperfect. It involves forgoing the maximum potential return. Nevertheless, it also eliminates a significant risk – ourselves. By extensively diversifying, we confront fewer choices regarding what to buy, sell, how much, and when. This mitigates the risk of impulsive decisions leading to undesirable outcomes.
Our research examining the gap between the returns of funds reported by investors and the funds’ average returns revealed that the gap was the narrowest among widely diversified allocation funds. This indicates that investors captured more of the funds’ returns.
Trading vs Rebalancing:
Diversification alone does not ensure our investment portfolio matches our risk and reward objectives. Ideally, we would adjust our asset exposures in anticipation of market movements to gain profits and avoid losses. However, the reality of tactical allocation mutual funds shows that market forecasting is difficult, and tactical funds failed to outperform a simple 60% U.S. stocks/40% U.S. bonds portfolio over the past ten years ended January 31, 2023. By contrast, rebalancing our portfolio regularly can mitigate the risk of making sweeping changes to asset allocation that could jeopardize long-term financial security.
Alpha vs Indexing:
Although there are outliers of 10-bagger stocks and market-beating active funds, research indicates that almost all stocks and most fund managers underperform their indexes over extended periods. Even if some investors attempt to profit from outperforming securities by jumping from one to the next, the high costs and tax implications likely negate any excess returns they manage to achieve. While indexing may provide returns that are only average before fees, the market’s average return frequently surpasses what most individuals can expect to earn from active management after fees and taxes.
Yield vs Total Return:
In an ideal world, we would possess a collection of assets that generate enough income to meet our financial needs while also reinvesting the rest. However, investing solely for yield has its risks. To attain higher yields, we may need to compromise on liquidity or expose ourselves to greater credit and interest-rate risks. We may also find that high yields result from the use of leverage, which can cause significant losses if borrowing costs increase or underlying investments experience a downturn. Investing for total return offers a better balance of risk and reward by pairing income-generating assets with stocks, which can provide potential upside through capital appreciation. This approach may also offer better tax efficiency, as less of the return stream is taxed at ordinary income tax rates, capital gains can be deferred, and there are opportunities to harvest losses to offset income and gains.
Building vs. Buying
Constructing a portfolio brick by brick can be a tempting approach for investors, as it allows for greater control over individual holdings. However, for many investors, this approach can lead to a complex and distracting portfolio that ultimately results in poor choices. Instead, investors may be better off buying a single, diversified holding like a target-date or target-risk fund, which provides diversification with fewer moving parts.
Conclusion
Investing can be difficult, as the markets do not always behave as we would like. Rather than trying to invest in the best individual securities or building complex portfolios, investors are better off focusing on simple, controllable strategies such as regular savings, broad diversification, low costs, and total return. While theoretical perfection may be impossible to achieve, practical and effective investment plans are within reach.