Build a Strong Foundation for Long-Term Investment Success

A version of this article was published in the January 2019 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website.

Building a strong portfolio foundation is one of the most important things you can do to maximize your odds of investment success. That means setting an asset allocation appropriate for your risk tolerance; sticking to low-cost, broadly diversified funds; and investing for the long term. Tactical adjustments don’t move the needle nearly as much as getting the basics right.

Asset Allocation Drives Performance While investors spend a lot of time thinking about fund selection, asset-allocation decisions can have a much bigger impact on performance. Consider a portfolio with a 40% allocation to U.S. stocks, 20% to international stocks, and 40% to U.S. investment-grade bonds. If that portfolio were built with foresight using the managers who would go on to rank in the top 5% of the surviving funds in the U.S. large blend, foreign large blend, and intermediate-term bond Morningstar Categories over the trailing 15 years through November 2018 (rebalanced monthly), it would have returned 7.58% annualized. The corresponding value for a portfolio built with the CRSP US Total Market, FTSE Global All Cap Ex U.S., and Bloomberg Barclays U.S. Aggregate Bond indexes was 6.8%.

Achieving that type of success with manager selection is very difficult. Yet it would have delivered only a modest return benefit. Even for the best managers, most performance comes from exposure to market risk, not security selection.

Shifting the allocation between stocks and bonds is an easier, and more powerful, way to control risk and expected returns. There’s a clear trade-off between the two. As stocks are riskier than bonds, they must offer higher expected returns to entice investors to own them. That doesn’t mean they’ll always outperform. As the past few months remind us, stocks are more volatile than bonds, so they’re more likely to lose money and generate larger losses when they do. But they have richly rewarded investors over the long term, and it’s a good bet that they will continue to do so.

The easiest way to increase a portfolio’s expected returns is to tilt more heavily toward stocks. Moving from the 60/40 index portfolio of stocks and bonds described above to a 90/10 allocation (keeping the same ratio of U.S. to international stocks) would have boosted the portfolio’s return to 8.02% over the trailing 15 years through November 2018. However, the adjustment would have also increased the portfolio’s volatility, resulting in a less-favorable risk/reward (Sharpe) ratio. Exhibits 1 and 2 display the performance for several additional combinations of U.S. stocks, international stocks, and investment-grade bonds over the past 15 years, based on the three indexes mentioned above.

While it’s natural to focus on returns, risk tolerance should drive asset-allocation decisions. There are two reasons for that: The more aggressive the asset allocation, the greater the risk that you experience losses you are not prepared to absorb, which could prevent you from reaching your goals. Second, if you’re not able to stick with your portfolio through thick and thin, you could sell out at the wrong time and experience a high opportunity cost sitting in cash, waiting for the right time to get back in. Close to 72% of the U.S. stock market’s annual return from July 1926 through October 2018 came from its best 5% of months in that period. It’s hard to predict when the market will make those big moves. So, it’s best to find an allocation that lets you sleep at night and stick with it.

It’s easy to overestimate your risk tolerance when the stock market is booming and regret it when fortune turns. So it’s best to err on the side of caution. Occasional big losses in the stock market and gut-wrenching volatility shouldn’t come as a surprise to students of market history. The market can get scary, fast. The less willing or able you are to deal with that risk, the bigger role bonds should play in your portfolio.

Stocks Are a Good Long-Term Bet Time horizon should factor into how much risk to take. With a longer horizon, there is more time to recoup losses and a lower probability of finishing in the red. Exhibit 3 illustrates this effect. It shows the percentage of time U.S. and foreign developed-markets stocks underperformed U.S. Treasuries over different rolling holding periods.

With longer holding periods, underperformance was less frequent. That’s because stocks have considerably higher expected returns than Treasuries and their relative performance in each year isn’t perfectly correlated. So, gains in one year can offset losses in another, making long-term losses less likely.

That doesn’t mean that risk disappears over long horizons. While it is unlikely that diversified portfolios will lose money over the long term, catastrophic risk remains. For example, during World War II, the Japanese stock market lost most of its value, and something similar could have happened in the U.S. if it had lost the war. That said, international diversification can help mitigate this risk.

Inflated valuations can also lead to long-term losses, as the experience of the Japanese stock market in the late 1980s demonstrates. Japanese stocks had become so pricey in the late 1980s that the market didn’t overtake its high from February 1989 until 28 years later. Valuations matter. A longtime horizon may not be enough to save you from a speculative bubble.

Build a Strong Core With an appropriate asset allocation set, build it with well-diversified, low-cost funds that you can stick with. These should serve as the portfolio's core holdings, meaning that they should represent the bulk of the portfolio and remain in it regardless of what's happening in the market. This long-term focus not only promotes tax efficiency, but it can also prevent performance-chasing, which usually doesn't help.

Broadly diversified market-cap-weighted index funds, like Vanguard Total Stock Market ETF VTI, Vanguard Total International Stock ETF VXUS, and Vanguard Total Bond Market ETF BND, are a good place to start. These funds mirror the composition of the U.S. stock, international stock, and U.S. investment-grade bond market, respectively. It isn’t necessary to own the entire market to have a diversified portfolio. But it’s necessary to have good industry representation, have limited exposure to individual securities, and be intentional about the active bets in the portfolio.

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