[Editor's Note: Today's Tuesday Classic is about a popular topic — how to increase investment returns. Increased returns are great- they allow you to reach your goals sooner and/or save less money while pursuing them. But most of the time it means taking on more risk.]
How much money you end up with eventually is a relatively simple math problem. There are just four variables:
- How much you have now
- How much you save each year
- How many years you save for, and
- Your investment return.
The first you cannot change. Improving the second and third involve additional pain — i.e. cutting your lifestyle, working harder, or working longer. That leads many people to wonder about what they can do about the fourth variable –improving the investment return.
For example, let's assume you improve your investment return from 5% real (after-inflation) to 7% real. Assuming you're saving $50K a year over 30 years, that means you end up with 45% more money- $5.1M versus $3.5M. Or, alternatively, you could end up with the same money, but retire 4 1/2 years earlier. Or, you could save 32% less ($34,000 a year instead of $50,000 a year.) Those all sound really awesome, right?
Should You Try To Increase Return?
Unfortunately, there is a rule of thumb out there that basically says there is no free lunch. If you want a higher return, you're going to have to take on more risk. While that rule isn't always true–there are uncompensated risks out there, and that higher return is almost always just a higher EXPECTED return–it generally holds true.
One of the worst things that can happen to an investor is that you can exceed your risk tolerance. This could cause you to fail to contribute in a down market, fail to rebalance, or worst on this spectrum of bad investor behavior, cause you to actually sell low. There is some wisdom in the suggestion that you should take on just as much risk as you can stand, but not an ounce more. If you're not sure how much risk you can stand emotionally, I would suggest erring on the conservative side until you've been through a bear market or two.
There is some wisdom in the suggestion that you should take on just as much risk as you can stand, but not an ounce more. If you're not sure how much risk you can stand emotionally, I would suggest erring on the conservative side until you've been through a bear market or two.
This post is all about how you can increase your return. Most, but not all of these suggestions will involve increasing your risk. Only you can decide if that is a good trade-off for you. Taking risks that you don't have to take, and then getting burned when the risk shows up, seems awfully foolhardy.
9 Ways to Increase Your Investing Return
# 1 Eliminate Uncompensated Risk
This is one of the easiest to do, and probably the only one that adds on no additional risk at all. There is no sense whatsoever in taking on risk that you are not paid to take on. Two risks you shouldn't expect to be paid to take on include:
- Manager risk (i.e. investing in actively managed mutual funds) and
- Individual security risk (i.e. putting a large percentage of your portfolio into a limited number of individual stocks or bonds.)
Timing the market, even using valuations, could also be thrown in with these other uncompensated risks. Eliminating these risks may not improve your long term returns, but they will certainly improve your risk-adjusted returns, and over the long run, probably will both decrease your investing costs and increase your returns.
# 2 Decrease Taxes
There is very little risk involved in this step too. Most high-income professionals I meet aren't maximizing their use of tax-protected accounts like 401(k)s, cash balance plans, Backdoor Roth IRAs, and HSAs. They also know precious little about investing tax-efficiently in a taxable account.
Becoming smarter about taxes is a great way to boost returns, but there can be additional risk when you decrease your taxes. For example, deferring taxes lowers your bill now, and probably in the long-run, but there is a potential risk there to increase your total tax burden in the long run in some situations.
# 3 Decrease the Cost of Advice
Way too many physician investors are paying too much for their financial advice. That's not even considering the fact that many are getting bad advice despite spending a lot of money on it. Decreasing the cost of your advice by negotiating a lower rate with your advisor, moving to a lower-cost advisor, or learning to manage your own portfolio and becoming your own financial planner decreases your investment costs, and thus boosts your after-fee returns.
There is some risk there too, of course. Firing a good advisor and becoming your own advisor without learning what you need to know to do that effectively could be “penny-wise but pound foolish” but many doctors have boosted their returns, increased their retirement spending, and shortened their required working years by doing their own investments.
# 4 Increase Stock to Bond Ratio
Stocks have higher expected returns than bonds over the long run, primarily because the risk is higher. So the more of your money that you put into stocks (and similarly risky assets) the higher your expected returns, long-term. Want higher returns? Moving some of your money from bonds and cash into stocks and leaving it there will probably work.
# 5 Choose Riskier Stocks
Just as stocks are riskier than bonds, and have higher expected long-term returns, so some stocks are riskier than others. For example, small value, microcap, and emerging market stocks have significantly higher risks than US Large Cap stocks like Apple, GE, and Facebook. Theory, and long-term past return data, suggest you will have higher returns by including these asset classes in your portfolio, despite their higher costs.
# 6 Choose Riskier Bonds
The equity side is not the only place in your portfolio where you can take on additional risk. Some bonds have higher expected returns than others. While those bonds may not do as well in a financial crisis, and some of their higher return may be due to the fact that those securities are really part equity and part fixed income, the long-term data on their returns is quite clear — taking on additional term and credit risk increases returns.
An extreme example of this includes Peer to Peer Loans, an asset class I've invested in for the last few years. While my very safe bonds in the TSP G fund have made 1-2% a year, these bonds have made 10-12%, even after the frequent defaults. [Update 2019: I have been liquidating my direct Lending Club and Prosper investments over the last three years as discussed here. However, there are funds you can use that for substantial additional fees that provide a whole lot more liquidity than I experienced if you are still interested in this asset class. Personally, I prefer hard money loans backed by real estate if you want very high yielding fixed income investments.]
# 7 Add Alternative Asset Classes and Accredited Investments
Ideally, you want to fill your portfolio with assets that all have high expected returns but very low correlation with each other. So when you add an asset class, look for something with low correlation to the rest of your portfolio. That said, a pile of manure has low correlation to your stocks and bonds. If the investment doesn't also offer a decent rate of risk-adjusted return, take a pass on it.
The most common investment added is real estate, which enjoys similarly high returns to equities, but fairly low correlation. In addition, physicians and other high-income professionals, by virtue of being accredited investors, have access to a whole slew of investments not offered to those with lower net worths and incomes. Whether those investments are worth exploring is a matter of debate, but there is no doubt most of these at least promise higher returns than you can expect in the publicly traded stock and bond markets. Unfortunately, each investment is a totally separate deal, and must be evaluated on its own merits. The equivalent of index funds in this space simply does not exist.
# 8 Add Sweat Equity
Another way to boost returns is to put some work in. I'm not talking about work researching Exxon on the internet, I'm talking about putting labor into a business. That business might be an investment like a rental property down the street, or it could be an outpatient surgical center, imaging center, or free-standing ED. It might also be a website you purchased. Real estate advocates often brag about their high returns; however, part of their high return often comes from the fact that they've created value through hard work. Nothing wrong with that–it's a great way to boost returns.
# 9 Add Leverage
Leverage works. Unfortunately, it works going both ways. Borrowing money at 2-5% and earning money at 7-15% is a winning combination. Of course, nobody ever went bankrupt without leverage. There is no doubt there is additional risk when you start levering up your investments.
The classic levered investment is real estate, but there are other ways to lever your investments. For example, purposely carrying low-interest rate student loans or mortgages while investing is leveraged investing. You can also open a margin account or even use some types of options. This may be my least favorite way of boosting returns, but it is an option.
Which of these should you do? It's hard to say. I can tell you this though, I've done all nine of them in some way or other. Don't take any of them to extremes, but increasing your long-term by 1-2% a year can make a huge difference in your financial situation.
What do you think? What have you done to try to boost your returns? Have you tried any of these steps? Anything else? Is it working? Why or why not? Comment below!