We regularly come across clients who follow an indexing investment strategy. Indexing is not necessarily a bad thing; we follow what one might call an enhanced indexing strategy for our own portfolios. Indexing is usually an investment strategy that is associated with keeping investment costs low and investing in an entire investment index. With that said, indexing—at least the way we often see it done by clients—is not enough to be a successful investor. While costs and holding a wide array of securities are important to a total investment strategy, there is more to being a successful investor than merely selecting indexes and avoiding expenses.
First and foremost, investors need to keep asset allocation in mind. A failure to properly allocate one's portfolio is probably the most fundamental flaw we see investors make. We've all seen the pie charts that lay out sample asset allocation models (see sample, below). Contrary to what some might think, there's actually a lot of academic research behind the idea of asset allocation. In fact, the fundamental ideas behind such pie charts resulted in a Nobel Prize being awarded to three economists in 1990, and their ideas still lay the academic bedrock for investment success. In our own practice, we spend a lot of time on our portfolios to ensure that they represent an optimal amount of return for a given level of risk. We also work hard to avoid unnecessary risk, and we pay a lot of attention to a portfolio's Sharpe Ratio—a measure of risk-adjusted returns created by Nobel Laureate William F. Sharpe. Most portfolios are lacking important slices of the pie, or they have far too much invested in any given slice. Why is this important? It's important because it means the portfolio is often taking on far too much risk, which in turn means the portfolio is subject to more severe downward swings in a bear market (we can even play this sequence of events out further to the point that it means that one doesn't have enough money to fund one's standard of living in retirement or pay for important goals, such as a child's education or the purchase of that new RV). And, when entire slices of the pie are missing, a portfolio is not sufficiently diversified, something which could mean that the portfolio is taking on unnecessary risk, or could be losing out on substantial upswings in the market. Take the small cap asset class for example. In 2016, the Russell 2000 Small Cap Index returned 19.48%. If this were missing from one's portfolio (assuming one's risk tolerance makes such an allocation suitable), one would have missed out on an important component of total portfolio returns for 2016. In sum, if one follows an indexing strategy, yet doesn't hold a properly allocated portfolio, then the indexing strategy is fundamentally flawed.
People are often driven to indexing strategies because of their low cost. Keeping investment costs low is indeed important. Excessive expenses can result in a significant erosion of one's wealth over extended periods of time. With this said, if one has an average expense ratio that is .50% - 1% lower than an alternative strategy, yet makes the mistake of holding a portfolio that is not properly allocated, then it's possible that one is missing the forest for the trees. In other words, one might have built a cheap portfolio, yet the portfolio could be underperforming, have too much risk, or possibly a combination of the two. This is analogous to someone who fills one's grocery cart with the cheapest products in the store and, after filling the cart with hot dogs, processed foods, and other cheap foods that are harmful to one's long-term health, proceeds to boast about how little was spent on the grocery bill. Sure, it was cheap now, but the health and financial costs of obesity and possibly the open heart surgery that comes later is not going to be cheap. The point is this: Investment costs are important, but they should not be the only, or even the primary driver of one's investment decisions. This is where some in the popular media are leading the public astray. By focusing too much on investment expenses and not enough on other important aspects of the investment process, we now have a generation of investors who think that buying cheap index funds is enough to become a successful investor. This is a fatal mistake. Sometimes paying for professional advice can more than offset the costs associated with that advice, especially it it results in the avoidance of a major investing blind spot.
Article Source right here: How to Be a Successful Investor: Why It’s More Than Keeping Costs Low