Vanguard's principles for investing success
Successful investment management companies base their business on a core investment philosophy and Vanguard is no different. Although we offer many specific strategies an overarching theme runs through the investments we provide to clients – focus on those things within your control.
Too many investors focus on the markets, the economy, manager ratings, or the performance of an individual security or strategy, overlooking the fundamental principles that we believe can give them the best chance of success.
These principles have been intrinsic to our company since its inception, and they are embedded in its culture. For Vanguard, they represent both the past and the future – enduring principles that guide the investment decisions we make.
Investors should set measurable and attainable investment goals and develop a plan for reaching those goals. Because most objectives are long-term, the plan should be designed to endure through changing market environments.
Without a plan, investors often build their portfolio bottom-up, focusing on picking individual investments rather than on how the portfolio as a whole is serving the objective. This ‘fund collecting’ behaviour can lead to concentrated and imbalanced portfolios, or it can lead to a proliferation of holdings that makes portfolio oversight difficult.
Disappointing results can also come from chasing overall market returns, an unsound strategy that can seduce investors who lack a well-grounded plan. Many investors are moved to action by the performance of the broad stock market, inducing them to ‘buy high and sell low’. Cash flows rarely precede outperformance, making performance-chasing a losing strategy for many investors.
We believe investors should employ their time and effort up front, on the plan, rather than in ongoing evaluation of each new idea that hits the headlines. This simple step can pay off tremendously in helping them stay on the path toward their financial goals.
Asset allocation and diversification are powerful tools for achieving an investment goal. Both are rooted in the idea of balance. When building a portfolio to meet a specific objective, it is critical to select a combination of assets that offers the best chance for meeting that objective 1.
The mixture of those assets will determine a large proportion of both the returns and the variability of returns for the aggregate portfolio. This has been well documented in theory and in practice. Vanguard research 2 confirms previous findings by showing that the asset allocation decision was responsible for 80% of a diversified portfolio’s return patterns over time.
In practice, diversification is a rigorously tested application of common sense. As the table shows, markets will often behave differently from each other – sometimes marginally, sometimes greatly – at any given time and performance leadership can shift randomly among markets and market segments. Owning a portfolio with at least some exposure to many or all key market components ensures some participation in stronger areas while also mitigating the impact of weaker areas.
Figure 1: Market segments display seemingly random patterns of performance and return variability
Annual returns for various investment categories ranked by performance, best to worst: 2000–2013
Notes: Large-cap equity: MSCI World Large-cap Index, Mid-cap equity: MSCI World Mid-cap Index, Small-cap equity: MSCI World Small-cap Index, Value equity: MSCI World Value Index, Growth equity: MSCI World Growth Index, Swiss equity: MSCI Switzerland Index, Emerging market equity: MSCI Emerging Markets Index, Swiss Bonds: Barclays Swiss Franc Aggregate Index, Global Bonds (hedged): Hedged Barclays Global Aggregate Index. Sources: Vanguard calculations, using data from Barclays Capital and Thompson Reuters DataStream.
Past performance is not a reliable indicator of future results.
1. For asset allocation to be a driving force of an outcome, one must implement the allocation using vehicles that approximate the return of market indices. This is because market indices are commonly used in identifying the risk and return characteristics of asset classes and portfolios. Using a vehicle other than one that attempts to replicate a market index will deliver a result that may differ from the index result, potentially leading to outcomes different from those assumed in the asset allocation process. To make the point with an extreme example: Using a single stock to represent the equity allocation in a portfolio would likely lead to very different outcomes from either a diversified basket of stocks or any other single stock.↩
2. Wallick et al. (2012)↩
Investors can’t control the markets, but they can control the bite of costs. The lower your costs, the greater your share of an investment’s return. In addition, Vanguard research suggests that lower-cost investments have tended to outperform higher-cost alternatives.
Every cent paid for management fees or trading commissions is simply a cent less that is earning a potential return. The key point is that – unlike the markets – costs are largely controllable. The impact of costs on investment returns can be significant, particularly over the long term. Costs compound over time just like interest, making the bite of costs ever larger the longer an investor’s horizon.
Costs are also the main reason why the majority of investors in any given market trail the overall market. In any market, the average return for all investors before costs is, by definition, equal to the market return. Once various costs are accounted for, however, the distribution of returns realised by investors drops below that average because their aggregate return is now less than the market’s.
In investing, there is no reason to assume that you get more if you pay more. That’s why investors choosing well-managed, low-cost funds tend to outperform those with similar higher-cost funds.
Figure 2: Lower costs can support higher returns
Average annual returns over the ten years to 31 December 2013
Notes: All mutual funds in each Morningstar category were ranked by their expense ratios as of 31 December 2013. They were then divided into four equal groups, from the lowest-cost to the highest-cost funds. The chart shows the ten-year annualised returns for the median funds in the lowest cost and highest cost quartiles. Returns are in sterling terms with income reinvested, net of expenses, excluding loads and taxes. Both actively managed and indexed funds are included. For funds with both income and accumulation share classes, we use only accumulation share classes to avoid double counting. Source: Vanguard calculations using data from Morningstar.
Past performance is not a reliable indicator of future results.
Investing can provoke strong emotions. Discipline and perspective are the qualities that can help investors remain committed to their long-term investment programmes through periods of market uncertainty and avoid making impulsive decisions.
Heightened volatility can induce investors to make changes to their asset allocation, often to curb losses in a bear market. This is understandable, but history shows that the worst market declines have led to some of the best buying opportunities.
Figure 3 shows the impact of fleeing equities during a bear market for stocks. In this example, the investor moves out of equities at the beginning of January 2009. The portfolio escapes the stock market’s further declines in January and February 2009, but it also misses out on the significant bull market that started in March.
Abandoning a planned investment strategy can be costly and research has shown that some of the most significant derailers are behavioural: the failure to rebalance, the allure of market-timing and the temptation to chase performance. That’s why even sophisticated investors should arm themselves with long-term perspective and a disciplined approach.
Figure 3: The importance of maintaining discipline: Reacting to market volatility can jeopardise return
What if the ‘drifting’ investor fled from stocks after the 2008 plunge?
Notes: The initial allocation for both portfolios is 60% global equity and 40% global bonds. The rebalanced portfolio is returned to this allocation at the end of each June and December. Global equity is defined as the MSCI All Country World Investable Market Index, unhedged in sterling. Global fixed income is defined as the Barclays Global Aggregate, hedged to GBP. Returns are in GBP with income reinvested.
Source: Vanguard, based on data from MSCI and Barclays.