No Crystal Ball Required: Getting Better Investment Returns (Without Guessing)

Imagine it's 30 April 1989. You just came into a hundred grand. You plan on investing this money for the next 20 years. Where do you put it?

Here are four options. No need to look them up on Morningstar (in fact, that would be cheating for today's exercise). Just glance at them and choose which of the four you think would have been the best place for your money over the past two decades.

  • Fidelity International Discovery (FIGRX): Invests in larger companies headquartered outside of the U.S., mostly in developed countries.
  • Fidelity Real Estate Investment (FRESX): Invests in real estate investment trusts (REITs), real estate operating companies (REOCs), and small pigs (RUNTs). Just kidding on that last one.
  • Vanguard 500 (VFINX): An index fund that seeks to mimic the performance of the S&P 500 index of generally large U.S. stocks.
  • Vanguard Small-Cap Index Fund (NAESX): An index fund that seeks to mimic the performance of the MSCI U.S. Small Cap 1750 Index of small to middle-sized U.S. stocks.

Go ahead and choose one, and just one. Where would you have committed your money for the past 20 years? Got one? Great. Now, let's see how they each performed since 30 April 1989, and how much your $100,000 would be worth today.

FundAvg. Return$100K Turned Into…
Fidelity International Discovery6.41%$346,605
Fidelity Real Estate Investment8.13%$478,046
Vanguard 5007.52%$426,704
Vanguard Small-Cap Index Fund7.44%$420,637

Source: Morningstar Principia software, 4/30/1989-4/30/2009

 

Did you pick Fidelity Real Estate Investment, the fund with the highest return? My guess is you didn't, not after what has happened in the real estate markets over the past few years. Perhaps you picked Fidelity International Discovery, since somewhere in the back of your mind is the recollection that international stocks beat U.S. stocks every year from 2002 to 2007. But that was the lowest-returning of our choices. And while it lost to the real estate fund by just 1.72% a year, that disadvantage resulted in $131,441 less wealth — an amount greater than the original $100,000 investment. Compound small amounts over many years, and you're talking big bucks.

The power of diversification
Now, when I asked you to pick just one of these investments, you may have resisted. “I would never invest all my money in just one fund,” you might have said. “That's too risky.”

You're so smart.

But while you know that diversification lowers risk, did you know that it can also boost returns? Let's see by creating a portfolio that is invested 25% in each of the aforementioned funds, and rebalance it annually. What do you think the average annual return on this portfolio would have been? Where would it rank among the returns of the four funds?

You can attempt to come up with an answer by doing a little math: Add up the returns of the funds and divide by four. That would give you 7.35%, which would have lagged all the choices except the international fund.

But here's the real answer: The four-fund portfolio, rebalanced annually, would have earned an average 7.81% a year, turning $100,000 into $450,279. That beat three of the four choices; the sum exceeded most of the parts, so to speak.

How did that happen?

A bit of balance
While each of the funds posted similar long-term returns, they often rose and fell in different degrees, at different times. This didn't happen each and every year; 2008 is a recent and painful example of how many investments can move in the same direction (i.e., down) at the same time. But looking over many years, some of these funds zigged while the others zagged.

Throw in some rebalancing — which entails selling what has done relatively well to buy what has not — and you're often getting out of a hot asset class before it turns cold, and getting into a laggard that's ready to become a leader. In fact, studies indicate that rebalancing annually is generally too much. Had we rebalanced our hypothetical portfolio every three years (something I can't do with the otherwise excellent Morningstar software I used to run these numbers), I think the return of the four-fund portfolio would have been a tad higher.

Yes, it lagged the No. 1 performer (the real estate fund). But here's the real beauty of asset allocation: You don't need to identify what will be the very best investment (which is pretty hard, if not impossible). No fortune-telling skills are required. You get very respectable returns without paying a psychic or selling your soul.

Final notes
Finally, I'll point out that I'm not recommending this exact portfolio or these exact funds; they were chosen because they have long-enough histories to examine (though I will say that I am partial to index funds, and own shares of the Vanguard 500). This is just an illustration of a neat little asset-allocation trick, which also works when you switch up the investments (as shown in this longer-term illustration).

A real-life portfolio should have even more assets, including bonds if you're financially conservative or within a decade of retirement. But that's a topic for another day.

For more investing information, check out The Motley Fool's Rule Your Retirement service.

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DDFD at DivorcedDadFrugalDad
DDFD at DivorcedDadFrugalDad
11 years ago

Nice post!

The secret to good investment returns is usually a long-term, disciplined, diversified approach as outlined.

Writer's Coin
Writer's Coin
11 years ago

But each one of those funds is already diversified. The Vanguard 500 already has a slice of 500 companies and the other funds own a whole bunch of equities.

At what point is too much diversification overkill?

andyg8180
andyg8180
11 years ago

From my short lived experiences, diversifying your long term investments is very key… short term investments would be better to put your eggs in one basket and monitor it closely…

the weakonomist
the weakonomist
11 years ago

@Coin, Seriously? First of all there is no such thing as diversification overkill. Secondly there is such a thing as asset allocation. Each of these funds invests in different asset classes. One in real estate, another in small cap, another still in international, and finally large cap. If anything buying these four funds alone still leaves too much exposure for many. There is no fixed income in there, the international is emerging markets (I think) and so doesn’t include investments in developed international companies, and there is no mid-cap exposure. For the purposes of illustration, this was a fantastic post,… Read more »

ObliviousInvestor
ObliviousInvestor
11 years ago

To be fair, rebalancing doesn’t always improve return. Depending upon the length of the period examined as well as the difference in return between the asset classes involved, “letting it ride” may produce a greater long-term return. In other words, regarding the title, there is, in fact, somewhat of a guess involved still.

Not that that means we shouldn’t rebalance our portfolios…)

Joe Light
Joe Light
11 years ago

@weakonomist and coin Yeah, I doubt these funds overlap much, but Coin is right that things start to get confusing if you buy funds that overlap. So if you bought the Vanguard Small Cap fund, the Vanguard Total Market Index, the Vanguard S&P 500 fund, and the Vanguard…I don’t know…target-retirement 2035 fund. Suddenly you have funds that each have a certain percentage in large cap, small cap, etc. and it’s hard to figure out what your overall asset allocation is. That’s not really being too diversified…just too many funds. But as you said, weakonomist, that’s not an issue in this… Read more »

ABCs of Investing
ABCs of Investing
11 years ago

I’m not convinced that rebalancing will help improve returns – as Mike (OI) said, sometimes it does, sometimes it doesn’t (sort of like dollar cost averaging).

I feel the main benefit of rebalancing is to make sure you maintain your desired asset allocation and desired risk level. For example someone who had 50/50 equity/bonds two years ago might now have an allocation of 60% bonds/ 40% equities which is less risky than what they originally wanted so they should rebalance back to 50/50.

Russ
Russ
11 years ago

On the subject of rebalancing, does it make much difference whether this is achieved by selling over-allocated funds and using the money to buy under-allocated funds (‘immediate’ rebalancing), or by adjusting regular investments over the next year (‘gradual’ rebalancing)? Another way of looking at it is balancing your current holding vs balancing your upcoming purchases. For instance, assume I have 25% in each of the four mentioned funds, and at the end of the year I have 26% international, 24% real estate, and the others still at 25%. I could either sell a bit of the international fund and buy… Read more »

Aaron
Aaron
11 years ago

@Oblivious @ABCs: In regards to the doubt that rebalancing will increase returns, it *is* possible that, especially in short-term periods, returns can be higher without rebalancing. As you increase the amount of time periods, this becomes less and less likely. The reason for this is mathematical in nature, assuming you have properly diversified across a wide variety of asset classes with low correlation to each other. Another way of thinking about this is to think back to 2004-2007, when certain asset classes (think international stocks/real estate) had exceptional back-to-back-to-back returns, and some other assets lagged in relative terms. All else… Read more »

Todd @ The Personal Finance Playbook
Todd @ The Personal Finance Playbook
11 years ago

Excellent post. Rebalancing is one of the main tools at our disposal that can be used to lower risk. It forces you to “buy low, sell high” like you always here about, because you are always selling your successes to buy your failures.

Investment Blogger
Investment Blogger
11 years ago

Is diversifying into different funds (which invests primarily in the stock/bond market) really giving genuinely different sources of investment return? Is it really reducing your investment risk? If you had all your investments in mutual funds, stocks, or bonds, when the market crashes the value of all of those most likely will be pretty low considering that the stock markets retreated back to the lows of the last 4-5 years or so. Some stocks, funds, etc never even really recovered from the times of the tech crash during the 2007 market highs. Something to think about might be how diversifying… Read more »

Tyler@Frugally Green
11 years ago

I love reading investment articles that written for the layman. I have a 401k that I have been contributing to for 2 years and am just now trying to expand beyond that, starting with some environmentally sustainable investments and then further diversifying into more asset classes. It’s a long road and can be very daunting when you’re just starting out. It’s articles like these that aren’t incredibly heavy on the industry lingo that can give some confidence to those just starting out. Thank you.

Aaron
Aaron
11 years ago

@Investment Blogger: “Is diversifying into different funds (which invests primarily in the stock/bond market) really giving genuinely different sources of investment return? Is it really reducing your investment risk? … Something to think about might be how diversifying into different funds reduce market risk if the funds are all invested in the market?” @Joe Light “things start to get confusing if you buy funds that overlap” A great point by you both, which takes us back to the definition of diversification: putting your eggs in different baskets. When looking for diversification, you must put a little effort into the strategies… Read more »

Will Crowthers
Will Crowthers
11 years ago

Love this post – outstanding!! There are so many theories, blog posts, books, guides and speakers that talk about diversification or asset allocation and never tell you how to do it. Have a simple guide like this is outstanding. But as we all know there will still be those that think they can outsmart it! Make it simple for yourself and take the great and very easy advice! If you want a deeper dive on asset allocation, but still very good direction on how to achieve asset allocation, I highly recommend The Intelligent Asset Allocator by William Bernstein – I… Read more »

Courtney
Courtney
11 years ago

@ Russ – I think it would depend on whether you are rebalancing a tax-advantaged or a taxable account. In the former, you only pay taxes when you cash out so you can sell your higher-performing assets in order to buy more of your lower-performing assets. In a taxable account, I believe you would have to pay capital gains taxes on the sale before you could use the money to purchase other shares…so in that case it would make much more sense to “rebalance” by altering your future contributions.

Daniel
Daniel
11 years ago

What about Munis, Municipal Bonds? I just bought one that pays 6.75% tax free. So depending on your bracket it really pays around 8 – 9 %

Adam
Adam
11 years ago

On the advice of this blog I put my life savings into RUNT and now I’m ruined.

Frugal Bachelor
Frugal Bachelor
11 years ago

30-April-1989 was about 35 days before probably the most important global political event of the past half century, which led directly to the opening and capitalization of the Chinese economy and the resulting economic explosion, which has been the fastest growing economy is the history of humankind – double-digit percentage growth for the last couple of decades. Which leads to my point: twenty years ago you could have never predicted this in a million years, and (surprise, surprise) China is not represented in this portfolio, and so did not ride China’s gains. 75% of the portfolio is in the USA… Read more »

Dave Shafer
Dave Shafer
11 years ago

All this does is force you to either sell high or buy low. And yes over time it will bump of the return a little. Now here is some food for thought, if you had invested that same $100K into Berkshire Hathaway it would be worth $1.429M almost triple your asset allocation amount. And twenty years ago most people did know about Berkshire’s success.
Diversification has its costs. So does passive investing [or asset allocation of index funds].

Patrick
Patrick
11 years ago

This is an excellent post. I recently read The Four Pillars of Investing and the book talks about the principles outlined in this post – properly allocating your assets. And yes, you are right, rebalancing keeps your risk level where you want it to be. I think rebalancing too often as he pointed out is not recommended – you miss out on some good gains – but you don’t want to let it ride beyond your risk level either. Thanks for the post.

Shaun
Shaun
11 years ago

Ohh, I loved this article. I hope to see more like it in the future. Motley Fool = Total Win.

My Journey To Billionaire Club
My Journey To Billionaire Club
11 years ago

According to the Book, The Intelligent Investor by Benjamin Graham, Motely Fools people always come up with such type of new strategies and claim to crush the market, but at the end, instead of crushing the market, they crush the millions of Investors who followed their advises. These type of Random pattenrs generate many times in the market. But they don’t have any siginificance…!!!

Dan
Dan
11 years ago

I am very knowledgable in finances. I have worked for a finacial firm and have my regulatory lisences. I will tell you one thing. Diversification and long term investing is for loosers. Actually this site is ridiculous. How come you want to go throughout life saving and being poor, just to retire and not be healthy enough to do anything? Why not educate yourself and be rich? Live a life of luxury. It’s more than possible in this great country.

Jan
Jan
11 years ago

Not bad, but most of this portfolio is invested in stocks.

Bogle would probably suggest you’d invest your “age in bonds”. So if you’re 30 now, that would mean 30% bonds and 70% spread over these four asset types.
Much safer.

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