Investing your life savings to give you the outcomes you’re looking for is an important element of financial planning. After all, investments are the fuel for your financial plan.
In this article, we set the jargon aside and explore an investment strategy that puts the odds of achieving your objectives firmly in your favour.
As a starting point, let’s look at the high-level differences between active and passive investment strategies.
An active approach to investment management often delivers lower returns after costs are deducted
When running an actively managed portfolio, the investment manager is seeking to win. This involves identifying stocks that they believe the market has currently undervalued, in order to outperform the market as a whole. Our human nature means we like to win, which is why this sort of strategy appeals to many of us. But the odds of an investment manager outguessing the market again, and again, and again, have proven to be slim1.
In their endeavour to beat the market, an investment manager will make changes to the portfolio on a regular basis, but each trade costs the investor money. Plus, the investment manager is paid high fees regardless of the performance they deliver. These costs add up over time and erode the returns you ultimately receive.
“Your portfolio is like a bar of soap; the more you touch it, the smaller it gets.”
Darcy Howe: Founding Member of Merrill Lynch Private Banking
After costs are deducted, only around 1% of active funds beat the market over the long term2. This is because it’s incredibly difficult to know in advance the right stock to buy, at the right time and price. And then when to sell them.
There’s also a risk that in the quest to achieve their performance targets, an investment manager can get it badly wrong. The most recent example being Neil Woodford.
Passive investment strategies deliver returns just below the market
A passive approach to investing takes a longer-term view, buying assets and holding them for the long term. A collection of market indices is typically used to determine the assets that are held in the portfolio. This lighter touch approach is more economical, allowing the costs of investing to be kept to a minimum.
As an investor in a passive investment strategy, you would expect to receive a return that’s close to that of the market, but just below, as a result of deducting only modest costs.
Evidence-based investing is a more systematic approach to investing
At Life Matters we weren’t entirely happy with either of these approaches, so, following extensive research, we decided to adopt a strategy that brings together the best of both worlds.
Evidence-based investing takes a methodical and structured approach to selecting the company stocks to invest in. It brings together Nobel Prize winning academic evidence that indicates that markets perform efficiently over time and that there are specific measurable factors that deliver growth over the long term.
While over 600 factors have been identified so far, only a handful meet the criteria to be included in a portfolio. For equities, just three factors explain about 90% of the difference in returns of diversified portfolios.
- Value: Stocks that are relatively cheap tend to outperform relatively expensive ones.
- Size: Small companies have higher expected returns than larger companies.
- Momentum: Stocks that have performed well tend to continue to perform well, at least for a short period of time.
Based on this measurable data, it’s possible to adjust portfolios to include more stocks with these specific factors, removing the need to base investment decisions on the opinions and instincts of investment managers.
While this may sound like new thinking, the research that sits behind it started evolving in the 1970s and has been expanded upon several times since. This academic research has in fact achieved several Nobel Prizes, as recently as 2013 for the work of Eugene Fama. It’s also widely supported by legends of investment such as Warren Buffett.
Utilising the power of historical evidence and measurable data is a sound way to protect and build your life savings. We work closely with specialists in this field to monitor the long-term suitability of the factors included and the alternatives available.
The reality is investment markets are unpredictable. But if harnessed in the right way, this shouldn’t make your future unpredictable.
Please note, the value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
1 In 1995 a study on the factors that determine portfolio performance showed that only 2.5% of a portfolio outperformance or underperformance was as a result of the stocks that were selected. Only 1.7% was due to the timing of the purchases and sales of the stocks. Source: Gary P. Brinson, L. Randolph Hood & Gilbert L. Beebower (1995) ‘Determinants of Portfolio Performance’.
2 Source: David Blake, Tristan Caulfield, Christos Ioannidis and Ian Tonks (2015) ‘New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods’.