Why cutting costs applies to your portfolio as well
2023 has begun very much the same way that 2022 ended for markets. Stocks and bonds have continued their volatile run, as investors attempt to make sense of the often-conflicting news on inflation, interest rates and the health of the broader economy.
These gyrations are rarely a comfortable ride, even for the most experienced investors, so it serves as a timely reminder for investors to trust three fundamental investing lessons.
In this climate, cost becomes an even more important consideration as investors seek out more cost-effective investment products.
To illustrate this point, consider an example where an investor holds an initial investment of $10,000 over 40 years.
In this example, if this investor had paid the average active investment management fee of 1.20% p.a., after 40 years of growing at a conservative 5% p.a., their investment would have been worth $44,452. But if the same investor had paid a 0.04% p.a. fee and received the same pre-fee investment performance, their nest egg after 40 years would have been worth $69,335- or 56% more.
Separate to portfolio costs, market gyrations are also a reminder of the importance of building a diversified portfolio.
Diversification can help reduce investment risk as different asset classes or investments don't always perform in the same way in prevailing market conditions. It's this reason why investors seek to combine a range of asset classes, such as shares, bonds and cash within a well-constructed portfolio.
The idea behind this concept is that poor performance in one area of the portfolio can potentially be cushioned by better performance elsewhere - so if equity prices fall, safe haven assets like bonds may cushion the impact of any sell-off in stocks. While this approach had a tough year in 2022 in terms of performance, long term historical data suggests this principle is still sound.
Investors can also look to diversify at an asset class level by turning to ETFs. Stock picking during periods of market volatility is a tough ask that the experts rarely often fail to get right. In fact, SPIVA data shows that 58% of actively managed Australian equity funds failed to beat the relevant benchmark in 2022.
As a result, investors might wish to instead look at index-tracking ETFs that provide diversified exposure to the relevant asset class, whether it be Australian or International shares, bonds or another asset class. ETFs of this nature allow instant diversification and provide exposure to the broad market that active managers often fail to beat.
Finally, investors should resist the urge to time the market. During periods of market volatility, investors might be tempted to sell down their investment portfolio after a run of poor performance.
Rather, if possible, investors should try to stay in the market. In fact, key investment literature backs the idea that investors often see better performance if they avoid attempts to time the market.
On the same topic, many investors are unfortunately guilty of "performance chasing", investing after a period of good returns. This is evidenced by the fact that an individual's returns from investing in a fund are typically lower than that of the fund itself.
Ultimately, the reality is that market volatility is rarely a good feeling for investors. But remembering these three timeless investment lessons can help turn the noise associated with market volatility and help investors through to the other side in good shape.
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