The decision of which asset classes to own is what ultimately drives the overwhelming portion of return within a portfolio (stocks vs. bonds, international vs. domestic, small vs. large, value vs. growth). Failure to focus a portfolio on what asset classes are most appropriate given an investor's unique circumstances is a common mistake made by novice investors as well as seasoned professional managers.
Expanding the thought...
Most portfolio managers focus on activities which ultimately mean very little - trying to pick the "right" stocks and time when to buy or sell. As a result - the most critical elements of returns are frequently neglected in pursuit of the small portion (research shows around 4%) actually in their control. In addition, these managers charge very high management fees - and also increase taxes and transaction costs as a result of frequent trading. When you consider that persistency (the ability to replicate excess returns) among managers is almost nil, the futility of hiring a high-priced manager becomes apparent.
- 96% of your return as an investor is dependent on the asset classes you own – not the stock picking within those asset classes
- Focusing on stock picking at the expense of dimensions which generate the greatest efficacy (size and value/growth) is foolish.
Traditionally, companies like Vanguard replicate commercial indexes (like S&P 500, Russell 2000, MSCI, others…) to provide low-cost returns of certain asset classes. While indexing is low cost and generates returns close to the indexes, this strategy actually fails in a number of respects:
- Replication of indexes generates inefficiencies of trading index-identified stocks on specific days along with other index funds. This competition to buy and sell is a cost to the index which reduces returns.
- Commercial indexes are merely a "description" of an asset class. That description rarely if ever contains the dimensions of the asset class which are the most attractive to an investor historically. For example, while the Russell 2000 Value is used to describe Small Cap Value, research shows that you can get more attractive exposure to the asset class by owning smaller and more "valuey" stocks than the index. Again, this decision on portfolio structure (how to best get Small Cap Value exposure) explains the returns.