The best investment strategy is one that is going to make you money! To be a little more precise a successful investment strategy will ensure your capital outgrows inflation (and do all this after you have paid taxes and transactions costs).
The investing decision can be broken down into 3 components which generate an investment strategy:-
1. The decision to invest
2. Asset Allocation – what weightings to give to each asset class (asset mix)
3. The Choice between Active investing (asset selection and timing) or Index investing (follow the market) to implement your decisions.
For an index investor asset allocation is very important; second only to total market movement which affects all asset classes. Research by Ibbotson and Ibbotson Associates demonstrate that “about three-quarters of a typical fund’s variation in…return comes from general market movement, with the remaining portion split roughly evenly between the specific asset allocation and active management.”
Research by Ibbotson and Ibbotson Associates demonstrate that “about three-quarters of a typical fund’s variation in a time-series return comes from general market movement, with the remaining portion split roughly evenly between the specific asset allocation and active management.”
Ibbotson explains by saying, “Most of the variation in a typical fund’s return comes from market movement. Funds differ by asset allocation, but almost all of them participate in the general market instead of just holding cash.” In other words, a rising tide – market movements – lifts all boats, and vice versa.
Of course individual investors cannot do much about market movement except ensure they are invested, but they can do something about asset allocation. With regards to why asset allocation is important refer to this article asset allocation explained – a simple portfolio.
Active Investing versus Passive Investing
The choice between active and passive investing is one each investor needs to make. Active investing requires active and continuous decision-making about which assets to buy and sell, in order to achieve superior returns against the market average (index). This method necessitates asset selection and market timing. Sounds good but all this activity comes at a price for investors; both transactional and management fees deflate potential returns.
Passive investing or index investing on the other hand, accepts the market average (index); it is not concerned with asset selection, except to minimise investment costs. This constitutes the basic difference between the two strategies: hopefully superior returns at a cost versus average returns at minimal cost.
So which investment strategy works?
With respect to asset allocation, over the long term equities have produced the highest returns, but for a number of reasons an all equity portfolio is unlikely to represent prudent asset allocation. For more information refer to the Performance of Australian Asset Classes article.
With respect to active and passive investing it all boils down to whether active investing can achieve sufficiently above-average returns to surpass its extra cost factors.
The academics do studies year and after year and the answer tends towards the same conclusion. Around 70-80% of actively managed funds, under perform index funds over the long term after costs (also refer to this page ‘Are index funds are the best investment?)