Markets work
Capital markets are for most of the time, efficient and for investment purposes, assets are fairly priced. Competition between companies, investment professionals and freely available information tends to drive market prices to a fair value making it difficult for investors to achieve greater returns without bearing greater risk.
Risk and return are related
All investments carry an element of risk. Generally speaking, where there is less risk to your investment, your money will grow more slowly. With a more risky investment, the likelihood that you will lose money in the short term comes with a stronger probability that you will make more money over the longer term. A sound portfolio requires balance between the risk and the returns needed to reach your objectives.
We accept that this relationship exists and if it sounds too good to be true it probably is.
Diversification reduces uncertainty
Good investors can reduce their potential for loss by investing in a basket of different securities. In less technical terms, diversification means the same thing as the adage, "Don't put all your eggs in one basket."
Portfolio structure explains performance
Asset allocation principally determines results in a diversified portfolio. Asset allocation involves diversifying among several asset groups to improve total return whilst reducing risk. Academic research has provided evidence that an investor's asset allocation decision - the choice of asset classes and the portfolio percentage allocated to each - is the single most important element that determines the results of a broadly diversified portfolio. It accounts for 94% of a portfolio's performance compared with 2% for market timing decisions and 4% for security selection.
Index funds provide the best way to gain exposure to asset classes
Index funds capture the market return that every investor is entitled to. Investment in the different asset classes is gained at much lower cost than actively managed funds. Index funds avoid the additional risk of market timing or style drift which is inherent in funds which are actively managed. Study after study shows that when active funds do outperform benchmark indices, this is down to luck rather than skill and no more than would be expected by random chance. It just doesn’t make sense to pay so much more for random chance.