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The Most Important Determinant of Investment Returns

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Financial economists have demonstrated that the most important determinant of a portfolio's return is its asset allocation - the exposure to equity (and within equities the exposure to the risk factors of size and value) and fixed income (and within fixed income the exposure to the risk factors of duration and credit quality) assets. However, the most important determinant of the return realized by investors is most likely not the asset allocation decision, but is instead the discipline to adhere to a well-thought-out investment plan.

The noise of the market and human emotions often cause investors to stray from the game plan, inevitably leading to investment mistakes - typically buying high and selling low. During bull markets greed, envy, overconfidence, and confusing skill with luck often cause the loss of discipline. Investors also make the mistake of recency: projecting the most recent past indefinitely into the future as if it is preordained. Ignoring the complete historical record leads investors to jump on the bandwagon of yesterday's winners (buying high), and to abandon the ship of yesterday's losers (selling low). Not exactly the best recipe for financial success.

The endless noise thrown off by the market is a very difficult thing for most investors to ignore, be it the roar of the bull or the growl of the bear. But the pain of bear markets is especially difficult to ignore because the losses are real, compared to the "missed opportunities" investors lament during bull markets.

Another common "human error" in investing is overconfidence. It is my experience that most investors overstate their own tolerance for risk and losses. These brash souls often have a higher equity allocation than they really should. They believe they can stand the pain of a fifty percent or more market decline, yet when it actually happens they often find out too late that they don't have the stomach for it. Even if they resist the panic enough not to sell, portfolio losses can become a constant source of distraction and worry. And life's too short to not enjoy it.

Another mistake that often leads to too much equity risk is treating the highly unlikely as impossible. Though investors may know that terrible bear markets caused huge losses in 1929 and again in 1973, they simply treat the possibility of that type event occurring again as so unlikely as to be impossible (so they ignore it). Even in the face of the losses experienced by Japanese investors since 1989, most U.S. investors were probably ignoring the possibility of the kind of losses the Nasdaq has experienced since March 2000 - a seventy percent drop. Treating the highly unlikely as impossible leads to taking more equity risk than an investor can tolerate when the bear inevitably emerges from hibernation. Again more sleepless nights, ulcers - and unfortunately panic selling, usually at the absolute worst time.

All strategists know a well-thought-out plan is a necessary condition of success. The primary initial objectives in planning should be a thorough consideration of: the ability to take risk (determined by the length of the investment horizon and the stability of income), the willingness to take risk (with care taken not to overestimate the tolerance for risk), and the need to take risk (with a good rule being to not take more risk than is necessary to achieve your goals).

However, the best plan in the world means zilch unless an investor has the discipline to ignore the noise of the market and the emotions generated by that noise, to adhere to the plan, and only rebalance and tax loss harvest as needed. Paying attention to the daily market dramatics can cause our emotions to take over. There is an old saying from sports that is particularly relevant here: The best trades are often the ones you don't make.

08/23/2002

Larry Swedroe is the author of What Wall Street Doesn't Want You to Know and The Only Guide To A Winning Investment Strategy You Will Ever Need. His latest book, Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today, was published in June by St. Martins Press. Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.