THE BLOG
11/06/2007 10:13 pm ET | Updated May 25, 2011

Smart Advice for the HuffPost Investor

A reader believes he has found the magic bullet for huge returns. Is it luck or skill?

How do you invest to beat inflation? Are there special considerations involved?

Investing for retirement. Bond funds vs. a laddered bond portfolio. Which is best? Or is the answer "neither"?

I tackle these questions in this week's column.

If you have a question, please ask it by submitting a comment at the end of this blog.

Question From Bluesman48:

Jeez, I guess now I'd better sell that five star fund that's up 44 percent annualized for the last three years and buy the index fund!

You are really not asking a question, but your comment raises legitimate issues.

Your premise is that your selection of this high performing fund is based on skill and not luck. You also believe that your use of the five star Morningstar rating was predictive of these outstanding returns.

There is no data to support either assumption.

There is no academic study indicating that anyone has the ability to consistently select high performing funds The majority of actively managed mutual funds do not equal, much less exceed, their benchmark in any single year.

Do you have a skill that 97+ percent of mutual fund managers lack? They have been unable to match your achievement over a 10-year period.

Your skill has eluded at least six Nobel Prize Winners in Economics. It is also contradicted by the studies of Burton G. Malkiel, formerly a professor of economics at Princeton University and the author of A Random Walk Down Wall Street, Eugene F. Fama, a distinguished professor of finance at the University of Chicago, Roger Ibbotson, professor of finance at Yale University School of Management, and David F. Swensen, the Chief Investment Officer of Yale University and author of Unconventional Success, among many others who have spent their lives studying the capital markets and publishing their findings.

Your reliance on the Morningstar five star rating flies in the face of numerous academic studies.

One study found that "... there is a sharp drop off in performance after a fund

receives its first 5-star Morningstar rating." The same study concluded that the risk levels of these funds increased significantly after it was rated five stars.

Another exhaustive study concluded that "...high-rated funds (i.e., 5- and 4-star funds) do not generally perform better in the future than do 3-star funds."

Your selection of an out-performing fund is most likely the product of luck and not skill. Five star Morningstar ratings are not predictive of future high performance.

To answer your rhetorical inquiry, over the long term, you most likely would be better off with an index fund.

Question From SRT34:

Dan,

How do you recommend guarding against inflation? TIPS? Commodities?

The historical rate of inflation is 3 percent.

If investors bought and held almost any investment, they would outpace inflation. For example, here are the historical returns of various investments for the past 80 years:

Small stocks: 12.7 percent

Large stocks: 10.4 percent

Long term government bonds: 5.4 percent

Treasury bills: 3.7 percent

The problem is that investors, encouraged by their brokers and advisors, chase returns, to their detriment.

One study measured the average return of investors over a 20 year period ending in 2004. Investors earned only 3.7 percent during a time when the S & P 500 earned 13.2 percent per year. After inflation and taxes, the average equity investor lost money!

The best way to beat inflation is to have an appropriate asset allocation, to invest in low cost index funds and to hold on to your stock portfolio for as long as possible.

For the past 36 years, the returns of a very conservative portfolio, consisting of 80% bonds and only 20 percent stocks, was 9.01 percent. The worst three calendar year performance of this portfolio was a gain of 8.17 percent.

Smart, inflation busting, investing is really very simple. You just have to ignore much of the financial media and most brokers and advisors!

Question From BarryT:

What do you think about bond ladders vs. bond funds? Which involves the most risk for long term generation of investment income: a bond fund, or a carefully constructed bond ladder? Bond funds are highly diversified but appear to involve more speculation on interest rates. If the risk is higher for a ladder, is there a compensating increase in return? Finally, since (FDIC insured) CD rates seem to be close to those of bonds can CDs be included in a ladder to decrease risk?

This is a complex area and there is no definitive answer to your excellent questions.

My views are largely shaped by an article entitled A Synthetic Dividend. written by Eugene F. Fama, Vice President of Dimensional Fund Advisors,

There is a significant body of research indicating that long term bonds add a significant amount of risk over short term bonds, without much added return.

Long term bonds do not hedge against inflation. In fact, just the opposite. As inflation increases, the value of long term bonds decreases.

Laddered bond portfolios typically have long term bonds that have these negative characteristics.

In contrast, high quality, short term bonds offer better inflation protection, with less volatility than long term bonds. The negative is that the yields are lower.

So what's the solution to this dilemma?

Mr. Fama recommends that investors planning for retirement hold a portfolio consisting of an appropriate amount of stocks (represented by low cost, index or passively managed mutual funds) and short term bond funds, with maturities that vary according to changes in the yield curve.

Income from this portfolio would be derived from redemption of the assets (both the stock and the bond portions).

The benefit of this approach is that it focuses on total return, instead of just the yield from a laddered bond portfolio.

There are tax benefits as well. Assets held for more that a year are taxed a capital gains rates, instead of higher ordinary income rates.

For those investors who are not persuaded and want a portfolio consisting of just bonds, most investors would be better served by holding a low cost, index bond fund rather than a laddered bond portfolio. The benefits of the bond fund include greater diversification, professional management of cash flows and generally lower costs.

Of course, there are exceptions to this rule. A laddered bond portfolio gives superior control to the investor. For some investors, this control may offset the benefits of a bond fund.

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.