The New Year is here, which always inspires me to resolve to make positive changes in my life. You can do the same with your investing. You can elect to continue to rely on the recommendations of brokers and advisers who claim to be able to "beat the market," or you can take control of your investments and invest based on sound academic principles. Your broker hopes you won't learn the following facts:
Investing Fact # 1: Most individual investors underperform the market. You would likely achieve better returns in a globally diversified portfolio of low management fee index funds in an asset allocation appropriate for you.
Investing Fact #2: You probably believe you are a much better investor than your returns indicate. You may be seriously overestimating your returns. You can't fix a problem until you acknowledge it exists.
Investing Fact # 3: The fees charged by a mutual fund (called "expense ratios") are a better predictor of fund performance than Morningstar's much-touted star ratings. In general, the lower the fees, the higher the returns.
Investing Fact # 4: Reliance on forecasts is misplaced. The musings of self-styled financial pundits are bad enough. Worse still, according to William Sherden, author of The Fortune Sellers, even the most credible sources, like the Federal Reserve and the Council of Economic Advisers, have no better track records than you would expect from pure chance. Keep that in mind the next time your broker gives you his views about the direction of the market.
Investing Fact #5: You are probably ignoring Warren Buffett's advice. Brokers love to use Warren Buffett as an example of a great stock picker. Given Buffett's stellar track record, the message is clear: He can do it and so can you. Really? Your broker is no Warren Buffett. Buffett has consistently advised investors to invest in index funds.
Investing Fact #6: You probably aren't a better investor than managers of huge pension plans. Pension plans have resources not available to most individual investors. They can hire the best and brightest fund managers. They use sophisticated consultants to carefully screen the track record of funds before they invest. They pay lower fees than individuals because of the size of their investments. You would think they would have an enviable record of "beating the market." You would be wrong. A comprehensive study of 3,700 plan sponsors over a 10-year period found that plans hired managers based on a track record of market-beating past performance. However, post-hiring returns were "indistinguishable from zero." Do you really believe your broker will have any greater success in picking the next "hot" fund manager?
Investing Fact #7: You probably don't appreciate the difference between luck and skill. As Larry Swedroe notes in his book, Think, Act, and Invest Like Warren Buffett, it's not impossible to "beat the market." Many funds and individual investors do so every year. Given the millions of investors and tens of thousands of fund managers, you would expect outperformance by some due purely to random chance. If there are inefficiencies in the market that can be exploited by financial "experts," then there should be evidence of persistent outperformance beyond what you would expect from luck alone. A 2007 University of Chicago study looked at the performance of domestic stock mutual funds from January 1980 to December 2006. The author concluded even the "best" mutual fund managers "do not have stock-picking skills." If these managers lack this skill, do you believe your broker has it?
Understanding these facts should help you change your approach to investing. Here's my recommended action plan:
1. Dump any broker or adviser who claims to be able to "beat the market."
2. Ignore economic predictions.
3. Don't engage in stock picking, or market timing.
4. Don't invest in actively-managed mutual funds where the fund manager attempts to "beat the market."
5. Determine your asset allocation and invest in a globally diversified portfolio of low management fee stock index funds and appropriate high-quality bonds.
Dan Solin is the director of investor advocacy for The BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.
The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information, and content on this blog is for information purposes only and should not be construed as an offer of advisory services.
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