Create clear, appropriate investment goals.

We believe that investors should set measurable and attainable investment goals and develop plans for reaching those goals. Investors with multiple goals (e.g. retirement planning and saving for a child’s education) should have a separate plan for each. Finally, they should evaluate their plans on a regular, ongoing basis.

Without a plan, investors commonly construct their portfolios from the bottom up, paying more attention to choosing and buying investment products than to the process of achieving their goals. Investors without a plan often construct their portfolios by evaluating the merits of each investment individually. If the evaluation is positive, they add the investment to their portfolio, often without considering whether it fits. This process can lead to a mismatch between the portfolio and its objectives. Common, avoidable mistakes include performance chasing and market timing. Figure 1 provides an example of the framework for an investment plan.

Figure 1. Example of a basic framework for an investment plan¹

This example is completely hypothetical. It does not represent any real investor and should not be taken as a guide. Depending on an actual investor's circumstances, such a plan or investment policy statement could be expanded or consolidated. For example, many financial advisers or institutions may find value in outlining the investment strategy; i.e. specifying whether tactical asset allocation will be employed, whether actively or passively managed funds will be used, and the like.
Source: Vanguard.

¹ There are many definitions of risk, including the traditional definitions (volatility, loss, and shortfall) and some non-traditional ones (liquidity, manager, and leverage). Investment professionals commonly define risk as the volatility inherent to a given asset or investment strategy. For more on the various risk metrics used in the financial industry, see Ambrosio (2007).

Some investors may be influenced by the performance of the broad stock market, increasing stock exposure when stocks are performing well and reducing it when they’re not. Such behaviour is evidenced by investor cash flows, which tend to reflect emotional responses rather than more rational approaches. A sound plan should help investors avoid this type of behaviour and focus instead on asset allocation, diversification, rebalancing and saving and spending rates.

Vanguard believes that investors should spend more time on developing plans than on evaluating every new idea touted in the media. This simple reallocation of time can go a long way towards meeting investment objectives.

Develop a suitable asset allocation using broadly diversified funds.

We believe that a successful investment strategy starts with an asset allocation suitable for its objective. Investors should establish an asset allocation using reasonable expectations for risk and returns. The use of diversified investments helps to limit exposure to unnecessary risks.

When developing their portfolios, investors should select the combination of stocks, bonds and other investment types offering the best chance for success. This top-down asset allocation decision is among the most important factors in determining whether investors meet their objectives.

But why not simply aim to reduce the potential for loss and finance all goals through low-risk investments such as government-issued bonds? Because the decision to invest in more stable but lower-returning assets can expose a portfolio to other, longer-term risks, including the risk that an investment will fail to deliver the returns necessary to finance long-term goals. To reach their goals, investors might need to increase their saving rate – or they might need to decrease their future spending.

Figure 2 shows the relationship of two asset classes – US stocks and US bonds – to demonstrate the effects of asset allocation on both returns and the variability of returns.

Figure 2: The mixture of assets defines the spectrum of returns

Best, worst and average returns for various equities/bond allocations, 1985–2013

Note: Equities are represented by the MSCI World (USD) and bonds are represented by the WD Citicorp WGBI World All Mats Index(USD) (this index was used due to the longer history available but for other analysis of global bonds we have used the Barclays Global Aggregate Total Return Index).

Diversification is a powerful strategy for managing traditional risks. Within an asset class (such as stocks or bonds), diversification reduces a portfolio's exposure to risks associated with a particular company or sector. Across asset classes, it reduces a portfolio's exposure to the risks of any one class. It cannot eliminate the risk of loss, but it can help to protect against unnecessarily large losses resulting from the underperformance of one portion of the portfolio. Undiversified portfolios also have greater potential to suffer catastrophic losses.

Minimise costs.

Investors can't control the markets, but they can control how much they are willing to pay. Every dollar that investors pay for management fees or trading commissions is a dollar less of potential return. In addition, our experience has been that, historically, lower-cost investments have tended to outperform higher-cost alternatives in the long term.

Investors can improve their investment returns in two ways. First, they can invest in winning managers or strategies, but this can be difficult to do. Second, they can control the cost of investing. Low-cost funds simply take less of a bite out of returns than higher-cost alternatives do.

Figure 3 illustrates how strongly costs can affect long-term portfolio growth. It depicts the effects of expenses over a 30-year horizon in which a hypothetical portfolio with a starting value of $100,000 grows an average of 6% annually. In the low-cost scenario, the investor pays 0.25% of assets every year; in the high-cost scenario, the investor pays 1.36% or the approximate asset-weighted average expense ratio for US stock funds as of 31 December 2013. The potential difference to the portfolio balances over three decades is striking – a difference of almost $200,000 between the low-cost and high-cost scenarios.

Figure 3: The long-term impact of investment costs on portfolio balances

Assuming a starting balance of $100,000 and a yearly return of 6%, which is reinvested

Note: The portfolio balances shown are hypothetical and do not reflect any particular investment. The final account balances do not reflect any taxes or penalties that might be due upon distribution.

Source: Vanguard

Indexed investments can give investors the opportunity to outperform higher-cost actively managed investments because index funds generally operate with lower costs (but because index funds track a benchmark, they are unlikely to outperform the market in any event). The higher expenses for actively managed funds often result from the costs associated with trying to outperform the market (e.g. the research and transaction costs involved in buying or selling the underlying securities).

Maintain perspective and long-term discipline.

Investing can evoke emotion that could disrupt the plans of even the most sophisticated investors. Some make rash decisions based on market volatility, but investors can counter that emotion with discipline and a long-term perspective. They should adopt a systematic approach to investing based on the principles of asset allocation and diversification—and then stick to that plan.

Rebalancing brings the portfolio back in line with the asset allocation established to meet the investor's objectives. We believe that investors should check their asset allocation once or twice a year.

When stocks are performing poorly, investors may naturally be reluctant to sell, for example, bond funds that are performing well and buy more stock funds. But the worst market declines can lead to the best buying opportunities. Investors who don't rebalance their portfolios during these difficult times may be jeopardising their long-term investment goals.

Figure 4 shows the results of fleeing an asset allocation strategy during a bear market for stocks. In this example, the investor moves out of equities at the end of December 2008. The portfolio escapes the stock market's further declines in January and February 2009 (stocks dropped an additional 17% in those two months), but it also misses out on the significant bull market that started in March. Although this example is extreme, it reflects a reality for many investors: After abandoning exposure to an asset class, such as stocks, inertia makes it all too easy to postpone the decision to "get back in."

Figure 4: The importance of maintaining discipline: Reacting to market volatility can jeopardise return

What if the "drifting" investor fled from equities after the 2008 plunge and invested 100% in bonds?

Notes: The initial allocation for both portfolios is 60% global equities, and 40% global bonds. The rebalanced portfolio is returned to this allocation at the end of each June and December. Returns for the global equities allocation are based on the MSCI AC World Total Return Index in and returns for the bond allocation are based on the Barclays Global Aggregate Total Return Index in USD.

Source: Vanguard, using data provided by FactSet.

To meet any investment objective, an investor must rely on the interaction of the portfolio's initial assets, the saving or spending rate over time, asset allocation and market returns. Because the future market return is unknowable and uncontrollable, investors should focus on those factors within their control.