It certainly was a banner year for the Standard & Poor's 500 index, which gained more than 30 percent in 2013. If you are one of the investors whose portfolio lagged these returns, don't despair. There are sound reasons why your portfolio should not consist solely of the stocks that compose this index.
The S&P 500 is too risky for most investors, who need to allocate between stocks and bonds to cushion volatility. It's also not really representative of the U.S. stock market because it excludes smaller capitalization stocks. A more representative index of the U.S. domestic market is the Wilshire 5000 Total Market index. This index is the best representative of the entire U.S. stock market and includes all U.S stocks with readily available prices. A well-diversified stock portfolio would also include international stocks. Many experts believe the optimal allocation to international stocks ranges from 30 to 50 percent.
Even with a globally diversified portfolio, investors can still underperform the markets by engaging in self-destructive behavior. Stock picking, market timing, trying to select the next hot fund manager or investing in alternative investments are examples of such behavior.
Here are some tips to help correct this behavior and improve your expected returns. I obtained them from an article privately posted by Dimensional Fund Advisors. Full disclosure: Buckingham, with whom I am affiliated, uses Dimensional funds in portfolios offered to its clients.
1. Rewire your brain. Disciplined investing means adopting a plan based on the science of investing and sticking to it. Unfortunately, our brains work against this goal. Among the examples of faulty logic used by investors are:
--I should have foreseen the market crash.
--My criteria for picking winning mutual fund managers is "proven" to work.
--I can't let myself sell at a loss.
--I pick stocks based on my research.
Dimensional regards these thoughts as "mental errors," which are not supported by sound data.
2. Control your emotions. We all know markets move in cycles. When the markets are up, we feel elated with our investment decisions. When markets start to move down, we are consumed with nervousness and fear. According to the Dimensional article, "Following a reactive cycle of excessive optimism and fear may lead to poor decisions at the worst times."
3. Don't bounce in and out of the market. As I have explained, it's not prudent for most investors to have their entire portfolio invested in stocks that make up the S&P 500. The following example is intended to demonstrate why bouncing in and out of stocks is a dangerous strategy.
If you invested $1,000 in the S&P 500 in January 1970 and kept it in there until December 2012, your initial investment would have grown to $58,769, representing a 9.94 percent annualized return. I should note that you can't invest in the index, but you could invest in an index fund with a low management fee that tracks the index, like the Vanguard 500 Index Fund, which has an expense ratio of only 0.17 percent.
If you missed the single best day of returns, your annualized return dropped to 9.66 percent. If you missed the 25 best single days, your annualized return dropped to 6.33 percent. Bouncing in and out of the market makes it highly likely you will miss some or all of the best days.
The financial media and many brokers and advisors encourage trading based on their views of the direction of the markets. The data is very compelling in proving that doing so is harmful to your returns.
4. Reap the rewards of discipline. It is not easy to be a disciplined investor. Financial news is filled with genuine, and sometimes invented, crises on a daily basis, many of which encourage short-term thinking and short-term trading. For the past few decades, investors were confronted with some of the following news:
--BusinessWeek story announcing the "death" of equities
--The dot-com stock crash
--The terrorist attacks
--The subprime mortgage crisis
--Concerns over the fiscal cliff
I suspect most investors believed some of these events were a call to action to do something about their investments.
If you had the discipline to ignore this temptation and simply invested in a globally diversified portfolio of stocks that tracked the MSCI Global Equity index (which tracks returns for more than 75 countries in the developed, emerging and frontier markets) in January 1970, every dollar you invested would have grown to $34 by the end of 2012.
That's the power of discipline.
5. Change your focus. There is no credible evidence that anyone has the ability to predict the direction of the markets or the expertise to pick outperforming stocks or fund managers. Focus instead on capturing the returns of the global markets, using a well-diversified portfolio.
You can control expenses and turnover. You can stay disciplined.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, "The Smartest Sales Book You'll Ever Read," will be published March 3, 2014.
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