Why Size Matters in Your Investment Portfolio

As investors we are often lured into making decisions based on the potential return of our chosen investment option. We are encouraged to believe that a high return is the definitive measure of financial success. A higher return may not necessarily be the simple answer to having more money in your pocket.

So is it always better to chase investments with the highest returns? It's a point that is often overlooked due to its simplicity, but examining the size of capital invested, and what it means in real terms, is a crucial step in successful wealth creation and management.

Return means absolutely nothing towards the end result until the size of capital committed enters into the equation. Our decisions should be made with regard to the interplay between the return and the capital commitment, rather than the return figure alone. What really matters is the amount of return our investment will produce in absolute terms, and whether it will produce it safely and simply.

If $5,000 were invested at 50% and $500,000 invested at 5%, it is clear that the 5% return results in a real gain that is 10 times greater than the 50% return. The size of capital invested is important because the larger the capital base to begin with, the less need to take risks that are normally associated with a larger return. In order to obtain higher returns as investors, we must be prepared to accept a higher level of risk. Conversely, the more capital we have to invest, the lower the return we require and the lower the risk we need to take.

So, in effect, the larger the capital base, the more conservative we can become as investors, yet we can still manage to walk away with a good amount of absolute wealth created and the less need there is to chase a 50% return. This partly explains why so much household wealth is tied up in property and in our own homes. It is highly unlikely that any city suburb would return 50% a year. More likely, it would look like 5, 6, or 7%. This might not sound so impressive, but 7% on half a million dollars is a lot of money.

The media often espouses the virtues of doing well in property, but the same potential exists in anything that goes up by 7% had half a million dollars been committed to it. The nature of real estate - and one of its benefits, some would say - is such that we are forced to buy a large amount . We don't have the option of buying $5,000 worth, it is all or nothing - unlike shares where you have the choice to buy less.

And that's exactly what most of us do - as consumers, we generally don't go out and buy half a million dollars worth of shares in a blue chip company, for example. More likely, we'll make a conservative investment. But even if the company we invested in becomes a roaring success, a conservative investment of $5,000 is not going to get us very far at all.

The decisions we make should be motivated by considering the financial risks and outcomes rather than simply reacting to what looks good at face value. Making a 300% return on your shares, probably sounds wonderful to the untrained ear, but the success of the investment is dependent on what was invested in the first place. If it was $3,000 for instance, then a tripling in its value, in real terms, would mean very little indeed in the context of our overall wealth creation.

However, we are encouraged to believe that it is far easier to talk about the return as a standalone item, than examining it in the context of its capital commitment. This is a trend that is propelled by the media.

The rules of engagement within the finance sector need not be so complicated. They are in fact so simple that they are often missed by most of us. It just comes down to a basic understanding that we must look beyond the return percentage in order to make a rational and informed financial decision.

In order for return to be elevated to its status, the capital commitment must be factored into the equation first. And that's all it is: an equation. And not even a particularly complicated one.

It leads us to the most important lesson of all: being driven by sound and simple financial principles is what will ultimately lead to financial success, rather than making reactionary choices to what we might think sounds like the better deal.

Shakespeare probably didn't have investing in mind, back in 1596, when he wrote his infamous line, but it is one that still rings true today, and one that all prudent investors should study closely when making financial important decisions.