Investors often make the mistake of focusing too much on their returns over short periods of time (five years or less). They also often assess performance relative to some benchmark, such as the Standard & Poor’s 500 Index (S&P 500).
But for most people, true investment success is less about excess returns relative to a benchmark, and more about building a desired amount of wealth over a given time period.
Some investors rely on an active wealth manager, but finding one that generates alpha (the excess return of a fund relative to the returns on a benchmark index, adjusted for the volatility) can become the criteria for judging the success of their investments. Finding a manager or set of managers that can deliver consistent, wealth-building, and higher (excess) returns is also difficult.
While investment returns and performance are certainly important, realizing consistent alpha is fraught with uncertainty, and can be a real drain on your resources. This is especially true if you rely too heavily on investment returns to meet any investment goals, including those in the short term—such as for a major purchase of a home, car, or any other large purchase—and the long term, such as retirement.
But there is one investment strategy that can rival even the best active management strategies, and that is first understanding how much more you need to save toward your investment goal to beat the market, and then doing it.
By saving more toward your investment goals and increasing your wealth over time, you’ll improve your probability of success and even rival the best active management strategies out there.
The act of saving money is completely under your control. What’s even more possible is saving the extra amount per month required in order to achieve the same investment performance as that of a high-performing active manager’s. As a Betterment customer, you can find out how much more you need to save easily based on your current goals and investments, and you may be surprised to find out how little extra you need to save.
First, let’s break down the concept of investment alpha, and compare saving as a strategy which can beat trying to generate higher returns on investment.
A Hypothetical Investment Scenario
Let’s say you want to buy a home. You’ve already saved $15,000 and want to continue to save over the next 10 years toward a 20% down payment (or $80,000) on a $400,000 house.
You’ve decided that you’re going to achieve this goal by investing 100% in the stock market, which we proxy by using the S&P 500. Note that the S&P 500 has returned about 7.57% per year on average with annualized volatility of 15.4% since 1950.
For better or worse, we assume that these estimates will persist in the future. Whether or not this ends up being true is not important for this exercise as our analysis focuses on performance (in dollar terms) relative to the chosen benchmark.
We also assume a yearly inflation rate of 2%. Estimates based on our stock allocation advice show that, given an initial balance of $15,000 in today’s dollars, you’ll need to save roughly $395.98 per month in order to have a 60% probability of reaching your goal of $91,424 (inflation adjusted) by the end of a 10-year investment horizon. We’re just using 60% in this case for this analysis.
Consider this outcome to be your baseline scenario.
By finding alpha-generating solutions or additional saving, you can significantly improve any baseline probability of achieving your investment goals (in addition to your total wealth).
How do we improve the likelihood of achieving our investment goals relative to the previously described baseline scenario?
Alpha, and Why It’s Important
Alpha describes your investment returns relative to a benchmark, and like other statistical measures, it can vary significantly from its average.
Achieving an alpha of any amount per year is never guaranteed and any expected improvements to your investment outcomes are, likewise, uncertain.
The Pursuit of Investment Alpha
If we optimistically assume that we can add alpha of 1% per year, on average, on top of the returns of the S&P 500 benchmark, our end-of-period wealth is about $97,440, significantly above our $91,424 goal in inflation-adjusted terms.
The probability of achieving our investment goal also improves to about 66% (i.e., 6.04% percentage points above our original assumption). While this still leaves a 34% probability of not reaching our investment goal, we’ve improved our prospects in a meaningful way nonetheless. But as we argue below, generating 1% alpha in any given year for any manager is really hard. It is even harder (if not impossible) to deliver 1% alpha per year consistently.
Outperforming a benchmark in any given year is already difficult enough for the vast majority of active managers (funds).
Consider the following statistics from the Standard & Poor’s Indices Versus Active, or SPIVA® U.S. Year-End 2015 data. This report shows that 66% of 1027 large-cap funds underperformed the benchmark (S&P 500, 1.38%) during this past one-year period. The story gets worse for active managers over longer-term investment horizons. For five- and 10-year investment horizons, 84.1% and 82.1% of large-cap managers, respectively, failed to generate excess returns relative to the benchmark.2
Furthermore, from this same report, we find that large-cap fund managers in the highest performing quartile over one-year, three-year, five-year and 10-year horizons fall short of producing an average of 1% alpha over their S&P 500 benchmark.
You’re also unlikely to achieve the aforementioned performance improvements in your investment portfolio consistently over time through adding alpha.
For one, manager alpha is a highly variable and uncertain quantity. Research by AllianceBernstein suggests that excess returns delivered by active managers of U.S. stocks ranged from -8% to +5%.3 This range is high compared to an average annual alpha of 1%.
Adding an annual 1% alpha consistently4 on top of almost any benchmark would also essentially mean that you are able to select active managers that are well beyond the highest performance quartile, and do it year-after-year.5
Research from S&P shows that active managers do not persistently outperform benchmarks over time. Based on the SPIVA® Persistence Scorecard for January 2016, for example, relatively few funds consistently stay on top. That requires DIY churning of your portfolio to access the top-quarter managers, which could result in tax and transaction cost problems. Only 4.28% of the 678 domestic equity funds that were in the top quartile as of September 2013, managed to stay in the top quartile by the end of September 2015.
Furthermore, none of the 268 large-cap or 98 mid-cap funds considered in the report remained in the top performance quartile over a five year measurement period. This indicates a lack of long-term persistence in active mutual fund returns.
Now that we’ve broken down investment alpha and returns, we look how, to achieve long term wealth we could alternatively just save more each month.
So, to recap, in order to consistently generate 1% alpha per year, you’d need to:
- Identify one of the best managers among the 34% who outperformed the benchmark, net of fees, one year ahead of time, every year, for 10 years, and/or,
- Not have your turnover of managers cause significant tax drag in your portfolio.
Neither is guaranteed. But one strategy just might be, and that’s saving more toward your investment goal.
Saving More Beats Investment Strategies Over Time
Our research shows that by saving more, you can:
- Rival the best active management strategies out there in terms of increasing wealth over time and improving your probability of success.
- Replicate the performance of an active manager that consistently generates high alpha of 1% per year for your long-term investment portfolio.
How can you do this? Save an extra $37 each month.
Let’s go back to our hypothetical scenario where you’re saving $395.98 per month for your down payment on a new home.
Given a starting balance of $15,000, an objective for total wealth after 10 years of $80,000 ($91,424 inflation-adjusted), and an S&P 500 benchmark, we estimate that you would need to save just an additional $37 per month, or a total of $432.98 per month to reach your goal. (That’s only a bit more than Zagat’s national average of $36.30 for a dinner out!)
By saving more toward your investment goals, you can rival the best active management strategies out there in terms of increasing your wealth over time and improving your probability of success.
As illustrated by the charts below, saving a little more per month could achieve improved outcomes similar to what a really good active management strategy could deliver.
Alpha vs. Savings in Dollar Terms
Alpha vs. Savings: Probability of Success
In fact, when you save $37 more per month, you’re already doing as well as an active management solution that consistently delivers 1% alpha per year in terms of increasing your wealth by the end of the investment horizon (from an inflation-adjusted goal level of $91,424 to $97,440) and improving probabilities of successfully achieving your investment objectives (from 60% to about 66%). You can call this your “alpha equivalent savings.”
But what if you’re saving entirely for a different investment goal of your own? The same strategy applies for any goal, short- or long-term
You’ll need to figure out how much more you need to save per month to beat an active manager, and Betterment’s Portfolio Projections calculator makes this easy for you. See the projections calculator in action now.
Using Portfolio Projections the Advice tab, you can determine—just like in our hypothetical scenario—how much more you’d need to save each month to beat your current active manager. If you’re not yet a Betterment customer, you can get started with an account now.
Getting the highest take-home returns possible is helpful to any investor. But there are a number of factors from taxes to investment behavior that may get in the way of your quest for above average returns. While trying to beat the market is a game fraught with uncertainty, by opting to save more money every month, you are setting yourself up to win when it comes to your long-term investing goals.
1Over five- and 10-year horizons, respectively, there were 1104 and 672 large cap managers sampled, respectively. Download the SPIVA U.S. Scorecard for year-end 2015 report for more detail.
2Based on 1,269 active managers of U.S. stocks in the Morningstar U.S. Open-end Large Blend category. I believe this is net of fees, but if this is not the case, required equivalent savings would decrease. See Dwarf Manager Variability, Getting the Big Things Right.
3The author believes this is net of fees, but if this is not the case, the required equivalent savings would decrease.
4This is based on a 10-year horizon of recent past performance based on the SPIVA U.S. Scorecard for year-end 2015.
5See Does Persistence Matter? The Persistence Scorecard. The S&P Persistence Scorecard is a survivorship bias-free report that tracks the persistence in performance of top active managers over yearly consecutive periods. This report is released twice per year. Data for over 2530 funds are considered in the January 2016 scorecard.
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- It’s About Time in the Market, Not Market Timing
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- Tax-Coordinated Portfolio™: The Latest Breakthrough in Tax-Smart Investing