Decision #1: Diversification is the free lunch
Why do financial advisors sound like broken records about this topic?
Diversification is about the closest thing to a free lunch in capital markets, so you may as well get a huge helping of it. ~Ken French, PhD, Dartmouth College
One of the most important investment decisions you make is in determining your asset allocation, or how you choose to divide your assets between risky and safe investments.
Diversification across securities, sectors, and countries can help investors maintain their focus, potentially allowing them to avoid extreme outcomes that may result from a more concentrated approach. Global diversification significantly lowers portfolio risk without adversely affecting return. It’s important for any investor who wants to improve the reliability of investment outcomes.
Diversification does not eliminate the risk of market loss.
Decision #2: Active or Passive?
The second key decision concerns which strategy to use when selecting the funds to implement your asset allocation plan. Should you be a buy-and-hold investor? Or should you rely on recent performance to select funds?
Active managers try to beat the market through buying what they believe to be the right investments and avoiding the wrong ones and by market timing (getting in and out of the market) at the right time. Passive managers don’t try to beat the market, but aim to capture the markets’ return. They seek to maximize diversification and focus on keeping costs low in order to achieve greater potential returns.
Historically, 90% of actively-managed U.S. stock mutual funds did not beat their market index through 2017.
Why doesn’t it pay to chase fund performance? There’s substantial evidence that a buy-and-hold strategy has been the superior performer in all nine Morningstar style boxes (asset classes). Vanguard’s study Quantifying the Impact of Chasing Fund Performance results show:
Keep in mind with all investments that past performance is no guarantee of future results.
Decision #3: Location, location, location
By locating asset classes by their tax characteristics, you can increase the tax efficiency of your overall portfolio. In a total household portfolio that has tax-deferred (401k, IRA), tax-free (Roth), and brokerage accounts, utilize asset location to separate tax inefficient securities into tax-deferred accounts while keeping tax efficient securities in taxable accounts. With the increased popularity and growing account balances of ROTH and ROTH conversions, there will be substantial opportunities for tax-efficient placement.
In general, here’s how it works:
However, adjusting your asset allocation based on taxation could have significant unintended consequences. Tax rates change, tax brackets change, or your tax preferences may change. What was a logical tax location one year may turn out to be a poor choice a few years later. As always, it’s recommended to work with your tax professional or financial advisor before making changes to your investments with tax implications.
Decision #4: Fund Selection
For investors who have dug into the historical data and embrace passive investing, they can address the fourth key decision by then considering a strictly Index Investing approach or Asset Class Investing.
As a fiduciary, it is our responsibility to provide guidance squarely focused on what is in our clients’ best interest. Backed up by empirical research, we believe structure along expected dimensions can provide optimized portfolio design through Asset Class Investing. We arrived at this conclusion by reviewing historical performance of asset classes and philosophies of passive-approach custodians.
Many custodians offers index mutual funds and exchange-traded funds that track commercial benchmarks (indexes).
Asset Class Investing
You may take a strategic Asset Class Investing approach to indexing through effective global diversification with tilts toward value, small cap, and profitability.
Hopefully, a comparison of strategies will help you determine which passive fund family has the highest probability of success for your situation. How you invest your money for the long term could have major implications for your overall success because even the smallest increase in return could make a difference for not outliving your money.
There’s actually a fifth decision, which could be the most important. Know thyself.
Know if you have the time and track record of sticking to a well-designed investment strategy, rebalancing, maintaining efficient tax location of funds in multiple accounts, minimizing expense ratios and transactional costs, and keeping yourself accountable for your own investment progress.
Numerous studies indicate investors who work with an investment advisor historically earn 1-5% higher returns. Why? Fees are important to overall returns, but they are not the key issue for the majority of underperformance by individual investors. The key issues come down primarily to a lack of capital to invest (or rather, capital needed for other purposes) and psychology.
Costs are important, but emotional mistakes made by investors over time are much more important. The behavior gap between investor and investment returns could make a tremendous difference in the growth and stewardship of your hard-earned money.
Here’s why we believe what we believe for the best way to invest:
If this sounds like a smart investment strategy for your portfolio, contact us for an initial consultation by calling (916) 333-5760 or email (firstname.lastname@example.org).
*Asset Class Investing and diversification do not guarantee a gain or protect from a loss. Utilizing asset class investing involves risks, including the loss of principal that cannot be guaranteed against loss by a bank, custodian, or any other financial institution. To obtain performance data current to the most recent month-end access visit DFA’s website us.dimensional.com. Performance data represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost.