As an investor when you come to the conclusion that buy-and-hold strategy using passive index funds is a sure way to attaining long term consistent returns, next step is to decide how to implement it. You could take two routes – either go the DIY route or use a robo advisor. I would not recommend DIY route for two reasons 1) an individual investor cannot reduce investment costs as seamlessly as a robo-advisor can and 2) it is challenging to choose an asset allocation on your own that is suitable considering your risk profile and that will fulfill your investment goals. Yet, another option is to use a robo-advisor. By going with a web based investment platform, you get a highly diversified, low cost portfolio tailored to your investment objectives, and best of all, that suits your risk appetite.
Higher Risk = Higher Return For Asset Allocation
First off, asset allocation plays a significant role in achieving expected portfolio returns. Depending on your allocation, returns either improve or worsen. However, asset allocation in turn depends on how much risk you are comfortable taking on with your portfolio. If a 10% drop in the value of your equity portfolio is enough to render you sleepless at nights then you should probably not go overweight in stocks. On the other hand, if you are somebody who can shrug off short to medium term volatility in the stock market to seek higher returns over the long run then you should think of overweighting your portfolio in stocks. For instance, Vanguard offers investors with varying risk appetite different portfolios. Figures below share three specific allocation mixes using historical risk/return profiles based on annual returns from 1926 to 2015.
As you can see, average annual return keeps improving by adding more stocks to a portfolio. But this is just stock and bonds. Adding asset classes like REITs, alternative investments, commodities, etc will further improve the risk-return characteristics of the portfolio.
Diversify Globally and Keep Your Allocation In Check
To build such a highly diversified passive portfolio at a cost low enough so returns are not jeopardized, you need a robo-advisor. Algorithm based portfolio solutions offered by robo-advisors consist of low cost passive index ETFs which is practically like holding the entire market. The goal is to earn market return by indexing a portfolio to a broader market, index, or basket of assets. Thus, robo-advisors tend to achieve market returns. Because they use a passive strategy (low trading = low costs) and ETFs with low MERs (management expense ratios), the overall cost you have to pay to obtain a highly diversified portfolio is, thus, on the lower end of the costs spectrum.
A few robo advisors tend to deviate from market weights to generate higher returns but in reality end up performing same as the overall market or worse. Burton Malkiel, author of “Random Walk down Wall Street” who helped the launch of index funds back in the 1970s, strongly argues in favor of using low cost cap weighted index funds and says,
“The holder of a broad-based index fund will by definition achieve the average. In the presence of cost, investing has to be a negative-sum game. The broad market portfolio can be accessed through ETFs at very little cost. “Smart Beta” funds and ETFs charge annual fees that can be a very large multiple of those charged on standard capitalized-weighted index funds.” (Source: Wealthfront, “Smart Beta”)
It makes sense, after all. There have been numerous studies that prove that markets are, at best, random. There is no skill in predicting or timing the market. Then why try to pick winners in the market? One who wins in the stock market in a certain period is likely to lose in another period because investing has to be a zero sum-game.
If you can’t time the market, then what can you do as an investor to be better off in the long term? You can keep the costs as low as possible and hold a well diversified portfolio of passive index funds. Remember, these are the only two parameters that are in your control.
Have fun investing (passively)!