Does ‘set and forget’ investing still work?

Photo of Robin Bowerman, Vanguard Australia By Robin Bowerman, Vanguard Australia

min read

Research highlights how excessive trading erodes value.

There are many similarities between gardening and investing.

Several years ago, after an extensive property renovation, it came time to think about the garden landscaping and design. Low maintenance was high on the personal wish list.

No such thing, the landscape architect said. She was speaking relatively of course. A native garden is going to require a lot less involvement than, say, an intricate, decorative flower bed or large vegie patch.

But her point was well made and it equally applies to your investment portfolio: you cannot just set and forget it.

When markets are volatile and there is a lot of uncertainty on the geopolitical front, the notion of a “set and forget” approach to your investment portfolio seems in conflict with the real world. The daily headlines are a clear call to action, backed up by investment commentators trying to make sense of it all and forecasting the next hot trend to follow.

The other factor confronting the investor in 2017 is that the development of online trading platforms, discount brokers and products such as exchange-traded funds (ETFs) means it is just so much easier to do something – right now. Investors today have industrial-strength trading tools at their beck and call via online trading platforms, often for less than $20 a trade.

But just because you can does not mean you should. Neither does it mean you should be passive, uninvolved and just let things ride.

When the investment industry talks about active versus passive investing, it is usually talking about the contest of investment styles between picking individual shares based on a whole range of valuation criteria for your portfolio versus buying index-style products that give you exposure to a whole market or a segment of it.

There is a clear role for both in investor portfolios, but where active investing can destroy, rather than create, wealth is when it involves high levels of trading.

Beware excessive trading

There are numerous research studies that highlight the corrosive effect of excessive trading on long-term portfolio values. A personal favourite was the work done by US academics Brad Barber and Terrence Odean, in a paper written in 2000 and published in the Journal of Finance, titled ‘Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors’.

The research was based on the trading records of more than 66,000 investors over six years with a large US brokerage firm. The study found that investors paid a heavy price for active trading and underperformed the market return by around 5 per cent.

The bottom line is that frequent trading is more likely to make your broker rich than build your portfolio’s value over the long-term.

You only need to look at the record of one of the world’s greatest active investors, Warren Buffett. His well-documented approach is based on identifying value, holding investments for a long time and keeping transaction costs as low as possible.

It is probably a safe bet that while Buffett and Munger are two of the finest exponents of active investing, neither will be advocating that investors should trade more often.

Vanguard counsels investors to be short-term aware but long-term focused, so that they understand what is happening to their investments today and why, but that they remain disciplined in giving their investment portfolio time to work. It is akin to giving your garden time to grow and bloom.

There are a few simple concepts that demonstrate why long-term investing still works, despite seemingly uncertain times for investors.

  • Trust in long-term market growth and the power of compounding: The Vanguard Index Chart shows $10,000 invested across the Australian sharemarket in 1986 would have been worth around $200,000 by the start of 2017. This is despite severe market events, including the Asian currency crisis of the 1990s, the dot-com crisis of the early 2000s, the 2008/2009 global financial crisis and the 2015 Chinese market jitters that spread to Australia. By being able to ride out these inevitable downward market cycles, investors will be well placed to ride markets upwards when recovery takes hold.
  • Diversification is the key to weather-proofing portfolios: Rather than trying to continually optimise a portfolio so that it is right for market conditions on any given day, week or month, investors are best served by building portfolios that can weather multiple market conditions.
    For example, an investor who fled to cash at the trough of the Global Financial Crisis in early 2009 would have seen a return of 27 per cent by the start of 2016. An investor who shifted their portfolio entirely to bonds would have seen a return of 71 per cent over the same period.
    However, an investor with a 50/50 mix of shares and fixed income in their portfolio would have reaped a 93 per cent return, proving that being disciplined during rough market conditions and staying the course can pay off in the long run.
  • Think about risk, then returns: Many investors base their portfolio around desired returns. This can lead to disappointment, as investors tend to perceive capital losses as being twice as bad as making gains. Investors should instead ask themselves two questions: how much risk am I willing to take on, and what are my required returns?
    The answers to both will largely depend on an investor’s individual circumstances. For instance, a 20-year-old investor aiming to save for a house deposit over 10 years will probably take on more risk in pursuit of capital growth than a recent retiree, who is focused on generating income to fund their post-work lifestyle, which could last 30 years or more.
    In this case, both investors should have an idea of how much risk they will be comfortable taking on, and then what their required returns are to meet their investment objective. For example, the young investor might need a 6 per cent average annualised return over their regular contributions to their portfolio to meet their goal, while the retiree investor might need to generate 3 per cent income from their nest-egg to live comfortably.
    What is important is that investors have realistic expectations rather than trying to shoot the lights out with higher-risk investments.
  • Be disciplined about rebalancing: Taking a long-term view is not the same as “set and forget”. One of the challenging decisions facing investors is rebalancing. Once you have set your long-term asset allocation and risk tolerance, as markets move around your portfolio will inevitably move outside the allocation levels you are comfortable with. It is commonsense to rebalance the portfolio to stay within your comfort zone – ideally done with new savings cash flow.
    However, at times rebalancing requires selling down part of your best-performing investments and redirecting the money to the underperforming parts of the portfolio. That is where the rebalancing theory challenges the reality investors are living with.

Just like a good garden, investors are still best served by taking a long-term view, engaging in regular maintenance and accepting that it requires courage and conviction to see portfolios through tough market conditions.

About the author

Robin Bowerman is Head of Market Strategy and Communications, Vanguard Australia

From ASX

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