Smart Advice for the HuffPost Investor: Smartest Quiz Answers

02/20/2008 12:44 am ET | Updated May 25, 2011

My thanks to all of you who took the "Smartest Quiz".

The need for an understanding of these issues is best illustrated by one of my fellow financial bloggers, who gave the following advice:

"I am officially going on the record with this statement: the financial sector is pure investment poison right now. Most investors should avoid it like the plague."

He may be right and he may be wrong. The problem is that there is no evidence that predicting the future of the markets, or of any particular market sector, is a skill that exists -- much less one that you should rely on.

If anyone had this predictive ability, it would be the highly paid managers of actively managed mutual funds. Yet more than 95% of them fail to equal or exceed their benchmarks over a ten year period.

It is market timing, stock picking, active management and advisors who make a living engaging in these discredited practices, that should be avoided "like the plague."

Here are the answers to the "Smartest Quiz." When you read them, ask yourself how you can apply these basic principles to the way you currently invest. For many of you, it will involve a fundamental departure from your current investment strategies.

That is exactly the point!

Question # 1

What is the most important decision an investor can make about her investments?

A. Which stocks to buy

B. Which broker or financial advisor to use

C. Determining when the markets will go up or down

D. The division of your portfolio between stocks, bonds and cash.

The correct answer is D.

Asset allocation, the division of your portfolio between stocks, bonds and cash, is the most important investment decision you can make. In one seminal study of mutual funds, the authors concluded that "...on average, more than 100% of the level of fund return would be expected from policy return."

Question # 2

What is the most reliable source of stock market returns?

A. Risk

B. Stock fundamentals

C. The skill of fund managers

D. None of the Above.

The correct answer is A.

The studies of Eugene F. Fama and Kenneth R. French demonstrated that investment performance is almost exclusively related to the risk of the portfolio. Specifically, the amount of stocks and particularly, the amount of small and value stocks, held in the portfolio.

Question # 3

Which of the following consistently achieve market returns?

A. Investors who pick the best performing stocks

B Investors who are able to correctly time the markets

C. The top actively managed mutual funds

D. None of the above.

The correct answer is D.

Investors in low cost index funds will always achieve market returns, less costs, because they are investing in the market. Efforts to "beat the markets" add costs and diminish returns.

Question # 4

True or false, studies of investor returns over a 20 year period demonstrate that the average stock investor would have achieved more than triple her returns after inflation by investing in a one year Treasury Note.

A. True

B. False

The correct answer is A.

One study examined the average investor return on an investment of $100,000 after inflation and compared it to the return on a One Year Treasury Note for the period 1986-2005. The average investor return was $19,625. The gain on the One Year Treasury Note was $63,542.

Question # 5

On average, what percent of the top performing mutual fund managers are able to repeat that performance in the following year:

A. More than 70%

B. More than 50%

C. More than 25%

D. Less than 20%

The correct answer is D.

A study of 100 top fund managers from 1996-2006 showed that on average only 14% of them were able to repeat their performance in the following year.

Question # 6

Most mutual fund investors achieve returns that are a fraction of the reported returns of these funds. To understand why this is true, you need to understand which of the following:

A. Dollar cost averaging

B. Dollar weighted vs. time weighted returns

C. Standard deviation

D. None of the above

The correct answer is B.

Mutual funds typically report their returns over a stated period of time ("time weighted returns"). A far more significant number is the returns actually achieved by investors in the fund, who tend to move in and move out, usually at the wrong times ("dollar weighted returns").

Question # 7

There is grave concern that our economy might be headed into a recession. Given this concern, which of the following would be the most prudent course for investors?

A. Unload stocks and buy commodities

B. Unload stocks and buy short or intermediate term bonds

C. Change your asset allocation to a more conservative asset allocation

D. If your asset allocation is appropriate for you, do nothing.

The correct answer is D.

Predicting recessions, like other forms of market timing, is very risky business. If you have an asset allocation that is appropriate for your tolerance for risk and investment objectives, you will not have to sell into a down market and you will be positioned for the inevitable (but unpredictable) recovery.

Question # 8

A recent study compared the performance of mutual funds selected by investors on their own with broker-sold funds. Select the answer that most closely represents its findings:

A. Broker-sold funds outperformed by an annual amount of $8.8 billion.

B. Broker-sold funds underperformed by an annual amount of $8.8 billion.

C. The results of both categories of funds was about equal

D. None of the above.

The correct answer is B.

The study is Assessing the Costs and Benefits of Brokers: A Preliminary Analysis of the Mutual Fund Industry, by Daniel Bergstresser, Harvard Business School, John M.R. Chalmers University of Oregon, and Peter Tufano Harvard Business School and NBER.

It is available here.

Read it and ask yourself why you are relying on "market beating" brokers and financial advisors for investment advice.

Question # 9

One study compared the performance in 2006 of Jim Cramer's stock picks with a globally diversified, index portfolio consisting of all stocks. Which statement most accurately reflects the results of this study:

A. The Cramer picks had a return of 22.51%. The index fund lost 0.2%.

B The index fund had a return of 22.51%. The Cramer picks lost 0.2%.

C. The Cramer picks and the index fund had approximately equal returns, but both underperformed the returns of the S & P 500 index.

D. The returns of the Cramer picks and the index fund equaled the returns of the S & P 500 index.

The correct answer is B.

You can find the results here

Question # 10

For the 20 year period from 1987-2006, investors in Warren Buffet's company, Berkshire Hathaway, "beat the markets." Which of the following is the most accurate response to this statement.

A. True

B. False

C. False, because the returns of Berkshire Hathaway stock were the same as the returns of an index of emerging market value stocks, which had a similar risk.

D. True, because the returns of Berkshire Hathaway stock were greater than the returns of an index of emerging market value stocks, which had a similar risk.

The correct answer is C.

During this period, Berkshire Hathaway returns were the same as the returns of an index of emerging market value stocks. Both had similar risks, as measured by standard deviation. Investors in both Berkshire Hathaway stock and the index took similar risks and obtained similar returns.

Thanks for taking this Quiz!

If you have questions, please add them as Comments to this blog and I will answer as many of them as I can.

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