Average Investor vs. Major Indices 1992 – 2011
are not properly compensated for.
Markets can be chaotic, but over time they have shown a strong
relationship between risk and reward. This means that the compensation for taking on increased levels of risk is the potential
to earn greater returns. According to academic research by Professors Eugene Fama and Ken French, there are three “factors”
or sources of potentially higher returns with higher corresponding risks.9
1. Invest in Stocks
2. Emphasize Small Companies
3. Emphasize Value Companies
Average stock investor and average bond investor performances were used
from a DALBAR study, Quantitative Analysis of Investor Behavior (QAIB),
03/2012. QAIB calculates investor returns as the change in assets after
excluding sales, redemptions, and exchanges. This method of calculation
captures realized and unrealized capital gains, dividends, interest, trading
costs, sales charges, fees, expenses, and any other costs. After calculating
investor returns in dollar terms (above), two percentages are calculated:
Total investor return rate for the period and annualized investor return rate.
Total return rate is determined by calculating the investor return dollars as a
percentage of the net of the sales, redemptions, and exchanges for the period. The fact that buy-and-hold has been a successful strategy in the past
does not guarantee that it will continue to be successful in the future.
A groundbreaking study by leading institutional money manager,
Dimensional Fund Advisors LP, found that exposure to these
three risk factors accounts for over 96% of the variation in
portfolio returns.10
So, the presence or absence of Small and Value companies in
your portfolio as well as your exposure to stocks may have a
substantial impact on performance. And additional asset classes, such as Real Estate and International, help provide further
portfolio diversification.
Threat 7: Lack of Diversification
“Don’t put all of your eggs in one basket.”
As an investor, you may have heard this old saying used to
emphasize the need for a diversified portfolio.
Though diversification does not guarantee a profit or protect
against a loss, a combination of asset classes may reduce
your portfolio’s sensitivity to market swings because different
assets — such as bonds and stocks — have tended to react
differently to adverse events. For example, the stock and bond
markets have historically tended not to move in the same
direction; and even when they did, they usually did not move
to the same degree.
To take a historical example: As the chart below shows, $1
invested in 2002 in a diversified equity portfolio including exposure to Small, Value, Real Estate, International and Emerging
Markets was worth $1.78 at the end of 2011.
Growth of $1 Investment Diversified Equity Portfolio
January 1, 2002 - December 31, 2011
Some long-term investors believe that investment success has
less to do with how well you pick individual stocks or the timing of when you get in the markets and more to do with how
well your portfolio has been diversified.
Just owning 10 different mutual or index funds, for example,
does not mean you are effectively diversified. These mutual
funds may have similar holdings or follow similar investment
styles.
In addition, investors who are not properly diversified may
have more risk in their portfolio or are taking risks that they
Diversified Equity Portfolio is weighted as 21% to the Dow Jones Total Market
Index, 18% to the Russell 1000 Value Index, 15% to the Russell 2000 (Small
Cap) Index, 26% to the MSCI EAFE Index (net div), 10%to the MSCI EAFE Small
Cap Index, 5%to the MSCI Emerging Markets Index, and 5% to the Dow Jones
U.S. Select REIT IndexData Sources: S&P 500 Index data are provided by
Standard & Poor’s Index Services Group, Russell Index data provided by The
Russell Company, www.russell.com Dow Jones Wilshire Index data provided
by www.dowjo- nesindexl.com; MSCI Index data provided by Morgan Stanley
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