8 Strategies To Increase Investment Returns
01 - Decrease Fees
This perhaps is the most significant drag on most people’s investment returns - the direct impact and cost of the financial services industry.
It's not uncommon to see people paying 2 to 3 percent of their assets to advisory and fund management fees. 2 to 3 percent may not sound like much on surface, but when we put it into dollar amounts, in a $10,000 portfolio we are talking about $200 to $300 dollars going into someone else's pocket instead of yours. And when we compound this over many years, we could be talking about thousands, if not tens of thousands.
When we can reduce these fees by 2 to 3 percent, it translates to a direct boost to investment returns. Now what is the most straightforward way to cut fees? The most obvious way is to reduce the expense ratio we are paying for our investments; a fee charged by the investment firm or a fund manager if it’s an actively managed fund.
Let’s say you have a sizable investment portfolio, around $1,000,000 and you’ve been paying a 2% expense ratio, $20,000 annually because it’s being managed by a fund manager. Again in my book, unjustifiable amounts given most actively managed funds fail to beat the market anyways.
But you fire your fund manager and learn to be your own financial advisor. And you start to invest your money in low cost broad market index funds. My favorite is the Vanguard Total Stock Market Index Fund, VTSAX and it has an expense ratio of 0.04%. This translates to $400 in expenses annually. Versus the $20,000 you were paying earlier, you automatically are saving $19,600 a year. Money that is staying with your investment, compounding and growing your net worth instead of funding your investment manager’s yacht.
02 - Max Tax Advantaged Accounts
Another common drag on returns on top of investment fees are the effects of taxes. Income tax we pay to take money home and capital gains tax we pay when we sell our appreciated assets. And the best and simplest way to reduce this tax drag is to invest in tax advantaged retirement accounts such as 401k, Roth IRA, defined benefit plan, and health savings account, aka HSA.
When you invest in these accounts, your money is sheltered from tax. With a traditional 401(k), you make contributions with pre-tax dollars, so you get a tax break up front, helping to lower your current income tax bill. Your money—both contributions and potential earnings—grows tax-deferred until you withdraw it.
With a Roth IRA, though you pay taxes upfront, all the money investment grows tax-free and withdrawals are tax-free in retirement. Less money to the government translates directly to increase in returns. If you would like to learn more about the optimal order to investing of these accounts, check out my post here where I delve deeper.
03 - Invest Tax Efficiently
Even after you’ve maxed out all your retirement accounts, there are still strategies to decrease some tax drag. There are naturally investments that are already “tax efficient” to begin with. Most often these are stocks and mutual funds that pay qualified dividends - dividends that receive favorable tax treatment.
And stocks and mutual funds that avoid paying out taxable capital gains distributions. Such distributions are typical of actively managed funds that engage in frequent trading in their portfolios. Most often broad stock market index funds check the box on both of these thus is a great example of an already tax-efficient investment.
The dividends it pays are modest and mostly “qualified.” And because trading (buying and selling) in the fund is rare, so too are taxable gains distributions. On the other hand, investments that are “tax inefficient” are those that pay interest, non- qualified dividends and those that generate taxable capital gains distributions.
Individual Stocks, Bonds, CDs and REITs fall into this category. And because of their tax inefficiency, we would ideally like to keep them in tax advantaged accounts that we talked about earlier, 401(k) and IRAs.
Therefore, if we need to, we can fit tax efficient investments like to broad stock market index funds into an ordinary brokerage account. It doesn’t mean it has to, but if we don’t have any more tax advantaged accounts remaining because we’ve maxed them all out, that it is ok to hold them in ordinary brokerage accounts. And this is the same with a broad international stock market index fund as well. The bonds and REITs are not as tax efficient. Therefore you want to prioritize placing it in a tax advantaged account if you can.
04 - Avoid Losing Strategies
There are some investing strategies in my perspective that just don't work well and should be avoided if possible. Most often success in investing, like life, is to just avoid big mistakes. One of the most common ones is investing in individual stocks. Regardless of what some tiktok influencers might say, the majority of us are just not good individual stock pickers.
Brad Barber and Terrance Odean are two Behavior Finance Professors from UC Davis and UC Berkeley who have done some extensive studies about the Average Individual Investor. Their research demonstrates some pretty interesting and consistent findings about the average investor. When it comes to investing decisions, if we are guaranteed to do one thing, it is to make the wrong call.
We believe that we are ahead of the trend, when in fact, we are chasing them.
We buy when the market is going up and sell when it is going down. There is no better way to lock in your losses. Talk about kicking you when you are already down.
We get too caught in past performances and make decisions that coincide with our emotions rather than logic.
By holding undiversified stock portfolios, we underperform the standard benchmark. This extends to other ‘speculative’ investments such as precious metals, cryptocurrencies and NFTs. I would even add actively managed funds in this bucket given they are essentially grouping of just individual stock picking. My general rule of thumb is if people are too excited about specific investments, I would bucket it under a potential losing strategy. Focus on slow and boring investments like index funds.
05 - Ignore The Noise
The truth is that experts who claim to know which direction the market is headed are nothing more than crystal ball gazers. In an annual letter to Berkshire Hathaway shareholders, Buffett once said that the only value of stock forecasters is to make fortune tellers look good.
Noone has more insight to know where the market is headed. But the sad reality is that just because they are clueless doesn’t mean they can’t do real harm. Because a lot of people do listen and use these predictions to time the market. When the market is tanking, selling might feel like you are making a wise move. And when you see the market continue to fall after you’ve sold, you might derive a bit of pleasure from it.
“Man, good thing I got out before it got worse.”
But, what happens is that most often, the pleasure is replaced by regret and stress because the market will almost always recover and now you need to time exactly when to get back in the market. And because timing the market requires incredible luck, we are often buying at the high.
We lost money when we sold and we are losing money when we buy. A prime example of how this kind of behavior affects returns comes from a study conducted by Market research firm DALBAR. In their 2020 Quantitative Analysis of Investor Behavior (QAIB), they compare the market returns vs. the average actively managed mutual fund managers’ returns over a 25 year period, ending 2019.
They found that over that 25 year period, the market had an average annualized return of approximately 10%. The actively managed funds, only 7.8%. And the key factor to this lackluster performance came from lack of patience on the part of the mutual fund managers. The average fund manager would only typically hold a mutual fund for only 4.5 years before cycling it with a new fund that could potentially do better. And all this switching in and out really hurt the fund performance - losing to the patient market by more than 2%. And in reality the loss is more than 2% because actively managed funds charge more than standard index funds.
If you want to be a successful investor, particularly on a long-term basis, you’ll have to learn how to tune out this kind of chatter. All it does is distract you from your own investment goals and strategies, and that won’t help you in the long run.
06 - Dial Up Stock Allocation
It is very important to understand that risk and returns go hand in hand. The higher the expected return, the higher the expected risk. If we want greater returns in our portfolio, we must get comfortable with greater risk. And our stock to bond allocation is a mechanism to control that risk level.
Vanguard research shows the average annual return and the worst single year return of various stock to bond allocation from 1926 to 2021. Let’s say that we went 100% stocks. Assuming the most risky asset allocation we can.
The average annual return would be 12.3%. But in our worst year, we would have lost 43.1% of our portfolio. This means if we had a $100,000 portfolio, in a single year, we could see our portfolio lose up to $43,000 dollars in value. This could be hard to swallow for many people. Especially if you were expecting to pull some of that money out soon.
So let’s say we decided to go 100% bonds. Assuming the least risky asset allocation that we can. In our worst year, we would have only lost 8.1% of our portfolio. Which is much better than 43.1% from our 100% stock portfolio. However, our average annual return is only 6.3%. Half what we would have gotten compared to the 100% stock portfolio. We took less risk by going with 100% bonds, but we also got less returns. If you want to increase your investment returns, you will need to dial up your risk tolerance and hold more stocks in your portfolio; regardless of how volatile it might make your portfolio.
07 - Play The Long Game
The worst delusion that any investor can get him or herself into is the get rich quick mentality. I mean why do we constantly have these bubbles? It’s Cryptocurrency and NFT now. It was the housing market a decade ago. And before that the .com craze. Dial back hundreds of years and at one point people were going crazy over tulips having delusional thoughts that they could get rich overnight. The promise that you can double or triple your money in just one or two years, in all frankness, is quite ridiculous.
Like building a great career or cultivating a healthy marriage, successful investing requires time and patience. When it comes to wise investing, don’t measure your time horizon in months or even years. Look at it for decades. That’s why I personally don’t think an investment’s monthly performance or even annual performance really matters. What matters is the long term prospect. The potential growth of American companies.
If you invest $100,000 in an index fund with an average rate of return of 8% and hold it for 30 years without ever touching it, you will eventually accumulate a portfolio of over $1 million dollars ($1,006,265.69). It's not a get rich quick scheme. And I know, slow and steady is quite boring. But it is one of the most effective ways for regular individuals like you and I to accumulate wealth - and at the end, that is what matters.
08 - Add Additional Asset Classes
I really debated adding this strategy given I think for most people, up to strategy seven is enough. But if you have done everything in this video up to now, I would say it's ok to look at some other asset categories. The general rule of thumb is that if you are to add an additional asset class, you want to look for something with low correlation to the rest of your portfolio. Different enough to make it worthwhile.
With that said, keep in mind a pile of hay has low correlation to stock and bonds. So if an investment has a low expected rate of return or is just too risky, take a pass on it. Don’t justify your purchase in the spirit of ‘low correlation.’
The most common investment that many people add at this stage is real estate. It enjoys a similarly high rate of return to equities but with low correlation. And this is what my wife and I did as well. Of course it sounds way cooler to say we are real estate investors versus index fund investors. But whatever other investments you explore, make sure to do your homework and evaluate it on its own merit.
