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Surprising Investing Myths

03/01/2012 06:44 am ET | Updated Apr 30, 2012

How you invest your hard earned money is critically important. It can determine whether you can retire with dignity or be dependent on friends and family in your "golden years." With so much at stake, you would think most investors would have a pretty good handle on how to avoid financial pitfalls. Unfortunately, this is not the case.

To help guide you through the mine field of investing traps, I have compiled some little-known investing myths. If you pay attention to them, you will be well on your way to improving your expected returns.

Most Investors Have Goals

I have advised many investors. When I ask them for their goals ("What do you want to achieve with your investments?"), I usually get a long pause on the other end of the line. Without a map, you can't get to a destination. You need a goal.

Establishing an Investment Goal Is Difficult

It's actually quite easy. I typically ask this question: "Would an acceptable goal be to come up with a plan that will maximize the possibility that you and your spouse (or partner) will not run out money during your lives, and which will permit you to maintain your quality of life?" Every time I ask that question, I get an enthusiastic "yes" in response.

Running the Report to Determine if My Goal Is Realistic Is Too Complex

The report you need is called a "Monte Carlo Simulation." It's not perfect because it is based on many assumptions. But it's based on long term historical data and it will be a good starting point for you to determine if you are on the right track. It requires relatively few inputs and you can run it yourself here.

The Biggest Decision I Need to Make Is What Broker or Adviser I Should Use

Initially, the biggest decision you need to make is whether you will engage in active management (where you and your broker attempt to "beat the market") or you will engage in index based investing, where you seek to capture the global returns of the marketplace, using a diversified portfolio of low management fee stock and bond index funds. This is a watershed decision and it is where most individual investors make a huge mistake. They are persuaded by the financial media, hundreds of millions of dollars of advertising money and the entreaties of brokers and active advisers to try to beat the market by stock picking, fund manager picking and market timing. The overwhelming data supports index based investing. You will find a helpful chart comparing active with index based investing here.

Once you decide to become an index-based investor, choosing a broker or adviser is quite easy. You will need to eliminate almost all brokers from consideration, since they tend to be proponents of active management. Most advisers fit into the same category. Only a relatively small group of advisers strictly adhere to the principles of index based investing.

Stellar Past Performance Is a Good Measure of Investment Skill

Every year, another fund manager is anointed as the "next investment guru" based on his recent past performance. It's more likely he was just lucky rather than skillful. It can take a very long period of time (often 20 years or more) to determine whether the performance of a fund manager was luck instead of skill. Relatively few fund managers stick around that long.

If Only I Qualified for a Hedge Fund Investment

Be thankful you don't. If you do, avoid the temptation. In his new book, The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True, Simon Lack concludes that hedge fund investors as a group would have been better off if they had simply invested in Treasury Bills. Lack bases his conclusion on publicly available data from Hedge Fund Research, Inc. Hedge funds are great investments for those who run successful ones, because of the excessive fees they charge: commonly 2 percent of assets and 20 percent of profits. This fee structure motivates them to take very high risks... with your money!

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of "The Smartest Investment Book You'll Ever Read," "The Smartest 401(k) Book You'll Ever Read," "The Smartest Retirement Book You'll Ever Read" and "The Smartest Portfolio You'll Ever Own." His new book, "The Smartest Money Book You'll Ever Read," was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated.

The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.