Investing doesn’t have to be complicated. All it takes is an investment in three index funds to build a diversified portfolio at very low cost.
However, many investors become very interested in making their simple portfolios more complicated. It’s completely natural. You are passionate about your finances and your money, and you want to do everything you can to maximize your returns. You know that small changes in your investment returns over time can make a big difference. For example, reducing the expense ratios of your mutual funds from 1% to 0.1% can be worth millions of dollars over the course of your career because of compound interest.
Here are some things that investors try to do (often in vain) to improve their investment returns:
Tweak their asset allocation to the latest trend
I don’t need to look at Yahoo! Finance to know how international stocks have been doing relative to U.S. stocks.
All I would need to do is start a thread on Bogleheads and ask for people’s international stock allocations. There is fierce debate about the role of international stocks in a diversified portfolio, so when international stocks are outperforming domestic stocks, you see more Bogleheads readers saying that they are 40% or 50% international stocks. When international stocks are doing poorly, or Europe’s economy is slumping compared to the United States, people run to the Warren Buffett or John Bogle camp that you don’t need international stocks.
Unfortunately, some investors will fall into the trap of jumping around from allocation to allocation — holding international stocks after a period of outperformance and U.S. stocks after a period of international underperformance.
Add additional asset classes
The big three asset classes are U.S. stocks, international stocks, and U.S. bonds. There are other minor asset classes such as emerging markets stocks, gold, oil, currencies, cryptocurrencies, and real estate. It’s tempting for a sophisticated investor to do something “different” from the crowd and try to start dabbling in these other asset classes.
However, adding 5% of your portfolio to a new asset class probably won’t make an appreciable difference in your portfolio returns. And if you’re saving a significant amount of money in your income, you will have a comfortable retirement without these extra asset classes. Could you have a little bit more money by adding more asset classes? Potentially. Could you achieve a slightly less risky portfolio by adding diversification through these alternative asset classes? Maybe. But that small difference in returns or risk probably won’t make the difference between a good retirement and a great retirement. As you get wealthier, additional money doesn’t make you significantly happier, and I doubt you’ll notice the difference between the risk or returns of a simple portfolio and a complicated portfolio.
Chase returns by purchasing individual stocks
Inevitably, almost every investor will have to try their hand at picking individual stocks. I certainly have. The problem with picking individual stocks is that it is impossible to know if your performance is due to luck or skill.
By picking individual stocks, you introduce much more volatility in your portfolio, without necessarily improving your expected return. By adding individual stocks, you begin to take away the benefits of diversification. Your stock portfolio becomes very sensitive to the moves of the individual companies in your portfolio. This can be a good thing if one of the companies you own gets bought out. But it can be disastrous if things go south for one of your stocks.
Use portfolio tilts
A portfolio tilt is when you overweight a certain segment of the total stock market because you believe it will provide excess returns compared to the rest of the market. For example, Eugene Fama won the Nobel Prize in part for his research that showed that small-cap stocks and value stocks have historically overperformed large-cap and growth stocks, respectively. Many investors try to increase their returns by tilting their portfolio towards small-cap or value stocks.
However, we just don’t know whether this outperformance will persist in the future. Past performance is not a guarantee of future returns. Of course, value stocks and small-cap stocks are more volatile than the general market, and investors should be compensated for that risk, but why use small cap and value stocks instead of just holding more stocks? And by tilting your portfolio towards small-cap value stocks, there’s always a chance you may have too much risk in your portfolio.
I understand that investing gets kind of boring if you just invest in a few index funds. Talking about investments with your friends at the dinner party or the doctor’s lounge is much more fun when someone is bragging about their investment in Nvidia stock or Bitcoin.
And I know that there’s a tendency for eager investors to try to maximize every cent out of their portfolio. But I believe that in investing, as in other areas of life, the perfect is the enemy of the good. By seeking to maximize your portfolio returns, you are expending energy that could be used elsewhere. If reading about investing and investment strategies is your hobby (like it is for me), you shouldn’t stop doing what you enjoy. But there’s always a chance that all that reading may make you want to tweak your portfolio just for the sake of tweaking your portfolio. Potentially, all that reading could be hurting your portfolio instead of helping it.
What do you think? Have you deviated from a simple portfolio of index funds? Do you think it will make an appreciable difference in your investment returns?
[Charts courtesy of StockCharts.com]