What drives the returns of any investment portfolio?
Specifically, from the moment someone starts saving for retirement, until the day they begin to take their required minimum distribution at age 70½, what are the factors that determine just how successful that portfolio is in terms of net, inflation-adjusted returns.
This is a more challenging question than you might think. Ask professional investors, and the responses cover a gamut of inputs, ranging from corporate profits, the economy, risk, valuation, taxes, interest rates, sentiment, inflation and more.
An unexpected challenge in performing this exercise is a tendency for some elements to offset others. For example, changes in profits could be offset by widening or contracting price-earnings ratios; sentiment might offset valuation; returns tend to vary inversely with risk. Why does this matter? Because in the real world, one hand giveth while the other taketh away. This concept of cancellation matters a great deal to total portfolio returns.
And so we are left with an intricate and difficult question. This is why complex, multivariate systems are so hard to assess by traditional analysis. What follows is my attempt to identify seven broad elements that typically determine the total return of any portfolio. Note that these elements progress from the least meaningful over a course of a lifetime to the most. Any given latter item can cancel out the effect of earlier ones.
On to the list:
No. 1. Security selection: Stock picking is what many individual investors and much of the media like to focus on. It’s a rich vein to consider, with traditional elements of narrative and storytelling, winners and losers. No doubt, better stock pickers will see commensurate portfolio gains. But that is merely one element of many, and not surprisingly, subject to other factors.
Consider the universe of active stock-picking mutual funds. The range of outcomes due to skill or luck is fairly broad. However, the net gains attributable to selection on average can easily be offset by any of the following.
No. 2. Costs and expenses: The overall cost of a portfolio, compounded over 20 or 30 years, can add up to (or subtract) a substantial amount of the returns. One Vanguard Group study noted that a 110 basis-point expense ratio can cost as much as 25 percent of total returns after 30 years. That does not take into consideration other costs such as trading expenses, capital-gains taxes or account location (i.e., using qualified or tax-deferred accounts).
The rise of indexing during the past decade is a tacit acknowledgment that on average, cost matters more than stock-picking prowess.