Many experts believe a lot of sins can be hidden if investors stick to some basic rules, such as staying invested over the long term, buying low and selling high, and diversifying across different asset classes.
But is there too much of an emphasis on whether you should tilt into bonds or equities? Should investors be spending more time researching the best portfolios rather than the vague asset class?
Diversification is great, but only if you have the best of all asset classes. Otherwise it can be almost negative to your portfolio.
There have been studies on this, including one from the 1980s that suggested 91.5% of returns were attributable to the mix of assets, with just 7% reliant on timing and selection.
However, this is a misquote. The study actually shows the asset allocation accounts for circa 90% of the variation in a portfolio’s quarterly returns, not the total return itself.
In reality, returns are a lot more nuanced than that. A follow up study by Ibbotson and Kaplan found “40% of the return variation between funds is due to asset allocation”, but the balance was due to asset class timing, style within asset classes, security selection and fees, among other factors.
I came across much of this from a blog post written for charities by Evelyn Partners. Author Nick Murphy pointed out that most investors – particularly those just starting out – make the mistake of concentrating solely on asset allocation.
This is because they invest using passive funds, with tilts towards different regions.
“Passive funds typically follow a momentum strategy where the strategy is to buy new stocks when they are expensive and sell them when they are cheap,” he said. In other words the antithesis of the buy low, sell high strategy recommended by experts.
In fact, it is so bad that one study found that from October 1989 to December 2017, the performance of stocks added to passive portfolios lagged those sold by an average of over 22% over the following year.
Of course, the rationale for using passives is that active fund managers can be just as bad, if not even worse, at picking stocks – something that is backed up by the data. Over the past decade, just 24% of the IA Global sector beat the MSCI World index, which has made 178.4%.
However, that is not the full story. Indeed, the top performer (MS INVF Global Opportunity) made more than double the index (363.9%) while there were four funds (including Fundsmith Equity) that made around 100 percentage points more than the benchmark.
Turning to investment trusts, around a third of the IT Global sector beat the index, although the top performer (Scottish Mortgage) made less than the best open-ended fund after its collapse over the past few years.
So even though most will continue to focus on asset split – which definitely is important – perhaps more time should also be given to picking the right funds, as the return difference can be stark.