The whole point of investing is to give yourself the possibility of earning better returns than you can get from a savings account. If you can find a way to make your money work just a little bit harder for you, maybe you can reach those long-term goals a little bit sooner.
But where do those investment returns come from? After all, they’re not just appearing out of thin air, and knowing what factors go into your returns can help you make better decisions about how to invest.
According to this paper by Roger Ibbotson (who’s kind of a big deal in the world of investing), there are three main factors that determine your investment returns. In this post, we’ll dive into each one and explain what it means for your investment decisions.
Factor No. 1: Whatever’s Going On in the World
By far the biggest factor in your investment returns is the one you have no control over. The current events in the world have a big impact on the overall market movements, and those movements account for about 75% of your personal return, no matter how you’re actually invested.
What this means is that the simple decision to invest instead of holding on to your cash will put you through all of the same big market swings that everyone else goes through. The fact that your specific investments are up or down at any point in time actually has little to do with how you’ve decided to invest. It’s mostly a reflection of what’s going on in the world around you.
And while this may make you feel a little powerless, you can actually use this information to your advantage.
The market is going to have big swings up and down from time to time. It’s just a fact of life. And when it does, most of the people around you are going to freak out.
When the market is up, people will start getting greedy. They’ll see their account balances rising and feel like they must be doing something right. So they’ll pull money out of savings accounts (where it’s “just sitting there doing nothing,” after all) and throw it into the market so they can earn more money.
When the market is down, people will get scared. They’ll think there’s something wrong with their investment plan and they’ll want to pull all their money out of the market, so they put it into savings accounts where it’s safe.
These are the kinds of reactionary behaviors that cause most investors to earn significantly lower returns than the market as a whole.
But you can know better. Whether your portfolio is way up or way down, you can keep a level head because you know that it doesn’t mean you’re a genius and it doesn’t mean you’re a failure.
It just means you’re investing.
Factor No. 2: Your Exposure to What’s Going On in the World
With all that said, you do have some control over your returns, and most of it comes from how much you decide to expose your investments to all those market forces above.
Technically, this is called asset allocation, and all it really means is how you split up your money among different types of investments, each of which exposes you more or less to those world forces.
At the high-exposure end, you have stocks. Stocks represent ownership in companies, and the fortunes of these companies depend heavily on what’s going on in the world. Therefore, investing in stocks will expose you to the biggest ups and downs (though over the long term it has always gone up).
At the lowest end of your exposure spectrum is cash, but just above that are bonds. Bonds are simply debt owed by companies or the government, and will still move up or down based on market conditions. But those movements are typically much smaller than stocks in both directions.
So your decision about how much money to put in high-exposure investments like stocks and how much to put in low-exposure investments like bonds will help determine how much your specific investment portfolio swings based on the news of the day. The higher your exposure, the higher your potential return, but the higher your ups and downs will be as well.
Factor No. 3: Your Actual Investments
The last and least significant factor is the actual investments you choose. The mutual funds you select. The stocks you pick. These decisions do matter, but they only account for about 10% of the return you end up receiving.
The big lesson here is not to let these decisions stress you out too much. It’s actually the need to pick specific investments, and not knowing how to do it, that often makes people anxious and keeps them from investing in the first place.
But now that you know that these decisions aren’t going to make or break your results, you should feel a little more free to try things out and maybe even (gasp!) make a mistake or two without feeling like you’ve ruined your future.
Still, every little bit helps, so to the extent you can, it’s a good idea to choose the best investments available to you. For that, I would simply refer to this post on index investing.
What Does This Mean for You?
There are a few important takeaways from all of this information:
- The simple decision to invest at all means you have the opportunity for big returns, but also that you’ll have to live through some big ups and downs in order to get them.
- The simplest way to manage your investment risk is by managing your exposure to the market through your mix of stocks and bonds.
- Do what you can to maximize the investment options available to you, but don’t worry about making a big mistake here either. In the end, it’s only a small part of your actual results.
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents build a better financial future for their families. His free book, “The New Family Financial Road Map,” guides parents through the most important financial decisions that come with starting a family.