Smart Advice for the HuffPost Investor: Two Sacred Beliefs That Could Clobber Your Returns

I challenge two sacred beliefs: Actively managed funds will outperform index funds in a bear market and your portfolio should become more conservative as you age.

Thank you for your insightful questions. Please keep them coming and I will do my best to answer as many as I can.

Question: A few months back you advised buying Vanguard. Now I hear they took a big hit in the sub-prime fiasco. What's your opinion of Vanguard now?

Answer: My advice to investors is to determine your asset allocation and to invest in a globally diversified portfolio of low cost index funds. Among the funds I recommend investors consider are the Vanguard Total Stock Market Index Fund (VTSMX), the Vanguard Total International Stock Index Fund (VGTSX) and the Vanguard Total Bond Index Fund (VBMFX). Similar funds are available from Fidelity, T. Rowe Price and other fund families.

My recommendations are limited to these funds. Investors who follow my recommendations own a slice of the entire global market -- the good, the bad and the ugly (sub-prime investments have been very ugly!).

These recommendations remain unchanged.

It is interesting to review how investors who followed these recommendations fared in the first quarter of 2008. Performance in down quarters is every bit as meaningful as performance in bull markets.

Here are the results for investors who followed the Vanguard fund recommendations and invested in one of the portfolios noted:

Returns: January 1 - March 31, 2008

You should compare these results to the performance of your hyperactively managed portfolio.

Conventional wisdom is that actively managed funds will outperform index funds in a bear market. You would think that this would be true because active fund managers have the flexibility to adjust to changing market conditions. Index fund managers do not.

The data does not support this belief. One study of six bear markets over a 12 year period found that the average loss for the S&P 500 was 15.12%. However, actively managed large-cap growth funds racked up losses of 17.04%. Yet the myth persists.

Question: Could you remark on the article "Hitting or Missing the Retirement Target" by Harold Schleef and Robert Eisinger that was written about in the New York Times recently? I found it depressing.

Answer: The Schleef/Eisinger study challenged a fundamental tenet of asset allocation: Your portfolio should become more conservative (e.g. have a higher percentage of fixed income) as you age.

The bottom line of the study is that investors might be better off if they picked an asset allocation while they were young and stuck with it through retirement, rather than slowly transitioning to a more conservative portfolio as they age.

The findings in this study are consistent with another study done by Gary Smith and Donald P. Gould, entitled: Measuring and Controlling Shortfall Risk in Retirement.

This study supports the view that the portfolios of older investors should have an optimal allocation of between 50 and 70% stocks in order to minimize the risk of running out of money.

Research in these areas is ongoing. However, based on these studies, it would be prudent for investors to consider whether their portfolios are underweighted in stocks.

The good news is that this research is causing the focus of investors to be where it belongs: On their asset allocation.

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.

Comments

[dogolaca]

Dan,

Thank you for an informative and entertaining blog and for elaborating on the index fund approach. Recently, Vanguard has introduced its "Managed Payout Funds" which combine index fund investments with more exotic instruments. The disclosure lists the investment mix as including index stock and bond funds, inflation-linked securities, and cash -- the bread and butter index funds. However, to reduce volatility, the investment mix also includes commodity-linked investments, market neutral investments (various derivatives), and an absolute return fund (which looks like a hedge fund).

The goal seems to be to act like a university endowment and pay out (depending on which fund) 3%, 5% or 7% of the investment value each year.

Do you have any thoughts on this strategy?

[Dunnage]

Ya, asset allocation. Great advice.

[Stevelagain]

This may help some of you.

My father is 80. My G*D is that possible?

He had a company retirement and 401K plan He also had some money in the savings account. When he retired he owned his small 3 bedroom brick ranch house and had no debt. He and mom have survived quite nicely on. He has never touched his 401K money except to start doing the mandatory roll over to a taxable account so Uncle sam could start taxing it.

They have gotten by on social security, company retirement, and once dipped into savings to buy a new car. That's it.

So if you are like my wife and I, feverishly stuffing money into our 401K plan...consider the fact that you can get by in retirement on less than they say you need. The money you are stuffing away, may be your children's inheritance, not your retirement life line!

You know what they say? Retirement money is money you save in case you live too long! Average life span is only an average. Half of us will die BEFORE the average. We all have to prepare for the worst, we might live to 103 but we should at least understand that we most likely will be fine and die before our money runs out if we are responsible.

Unless democrats continue to refuse to fix Mediare, Social Security, and to balance the budget.

[ReasonIsMyReligion]

BTW, the last balanced budget was under a Democrat.
And that was before a $500B war paid for with DEBT. etc.

I appreciate your wanting to throw out all da bums, but not all bums are created equally... bummy.

[ReasonIsMyReligion]

You had me at "hello," as they say in the movies.

You lost me at "Unless democrats..."

You may have been away the last seven years.

Fercrissakes.

[Stevelagain]

What does the past have to do with the democrats who are in power now and refusing to fix these issues now?

You can go live in the past if you can....I don't think it's possible. It's now the democrats turn. 1.5 years of failure is all we have seen. 1.5 years of failure.

Not until their base DEMANDS they fix these items will they do it.

[Stevelagain]

By the way when I say "useless democrats" or "useless republicans" I'm not referring to the voters. I'm referring to the useless democratic and republican parties and their useless candidates who refuse to actually resolve the major issues of our day such as Medicare, Social Security, Balancing Budgets, Stopping Ear marks and corruption, taking control of the boarders, settling the Iraq war, etc etc etc. The big stuff they don't do, the stuff that proves they are useless.

[Stevelagain]

That was the useless Republicans. They have been replaced by the useless democrats. Please show me the balanced budgtet bill, the medicare fax, the social security fix, etc.

Useless. All of them. Nothing but empty promises. Democrats will of course not admit they are failures. They point to their food to fuel (ethanol) bill as a triumph (while the worlds poor starve to death because their food is now going into our gas tanks). And now that they have their deadly ethanol bill to celebrate as "change" we see no intention at all to balance the budget, Fix Medicare, actually be fiscally responsible.

My wife and i have invested 50% of our assets overseas. If Obama gets in and starts raising taxes and punishing businesses and expanding government as he has promised to do, we will send another 25% of our assets overseas. No need to sink with the rest of the ship.

[pittising]

Dan, I am not rich like Rule and Reason and Zwack. I've tried to figure out how much to save for retirement. I've tried a lot of calculators. Some say I'm saving enough and some say not. Of course, you have to guess how much you'll need, and what inflation and your return will be over the next 40 years! I'm currently saving about 25-30 percent. This seems crazy to me. Is there any reasonable way to know how much to save? Thanks

[Rule Of Law]

If you are putting away 25-30% you are without a doubt one of the most disciplined and forward thinking people on this, or any board!

[ReasonIsMyReligion]

Good lord my friend, I am NOT "rich."

Except in love of life, nature, family... and the US Constitution.
(Salma Hayek and Uma Thurman would be there, but in the interest of avoiding spats...)

When I go on vacation... I look at the price of gas, not airline tickets.
When I go to the pharmacy... I look at whether the drug is Tier 1.
When I go to my car... I grumble about the repair bills on a 10-yr old POS.
When I get credit card offers... I look at how many months the balance-transfer teaser lasts.
When I take my kids to a baseball game... despite living in NYC, it's the Newark Bears.
When I go out for dinner.... I pass on dessert.
And when I go for my annual review... I pray the "raise" matches inflation.

I dare say that regardless of income, no American making those calculations is "rich."

If only ALL Americans could sock away "25-30 percent" of their incomes -- without getting berated for starving our credit-card consumerist economy. ;-)

P.S. My family's share of the Iraq War's *direct* costs to date -- $6,880 for the four of us -- dwarfs the $1,200 tax rebate I may or may not qualify for.
Oh wait, there's future interest on the combined $8k; there's no such thing as a free lunch, when you have to borrow it.
http://www.nationalpriorities.org/costofwar_home
http://www.irs.gov/app/espc/

Cheers.

[Rule Of Law]

Now Dan, I'm no Nobel Prize winner, heck I don't even have a silver bullet. But after getting out of the market last Fall, I just couldn't resist one of my best "picks," AAPL at just a little over $100. I just love their little Ipod and Mac thingys. And just today, I'm at $175 and change. Guess I shoulda put it in a index fund, huh? I'm out of it, though, when it hits $185. Can't afford to be greedy with a Depression coming.

[ReasonIsMyReligion]

Rule, you know I'm a fan, but.... I'm sure there were a lot of tech investors going neener neener just before the dot-com bust. Just sayin.

[Rule Of Law]

Hey Reason, where you been? Yeah, I know a lot of people who were wiped out just as sure as if they'd had a Enron retirement fund! That's why quality is the most important thing--in tech stocks or consumer goods like Walmart, Home Depot, etc...I know there can only be one genius to a blog, and I'm not him, and chances are I may never have that confluence of good fortune and common sense again. But it was a fun ride. Now I'm on the WIPatriot and Mrcontinental train.

[jaynevada]

Yes, you did well picking stocks so now you are here beating your chest about it.

What about all the one who picked the losers? We are not going to be hearing from them anytime soon.

It's a mathematical fact that the average of all actively managed portfolios must equal the market index. After that you take away management fees and it means that at an average an investor in active funds is a sure loser.

[ReasonIsMyReligion]

Re "It's a mathematical fact that the average of all actively managed portfolios must equal the market index."

At the risk of being a math dick, I beg to differ. But not in spirit.

You are assuming the entire market is held in actively managed portfolios, or index funds. What if there are passive funds that are NOT indexed?

[zwack000]

Well "Rule of Law" I'm not very good at individual stock picks as my experience shows but I'm have done well with index funds and allocation considerations both bull and bear in the stock market long term. Occasionally I have weakened and played individual issues and about 10% have been near jackpots. I won't tell you what happened with the other 90% but my girlfriend is sick of my whining about it. So tell me how many of these jackpots you have experienced. Do you have any more jackpots you can share with us now. I would love to setup a long term retirement portfolio using your stock-picking expertise. May I ask how reliable your stock advice would be. Waiting with bated breath.

[Rule Of Law]

Dan, thanks for the reply. I'm the first to admit that I'm just a lucky guy. And that the tech companies I played are all still around and going strong. That's gotta be luck, right? And I have a bunch of picks that lost me money, too--in fact, is your girlfriend related to my wife? :) Other than AAPL I'm not even in the market now, having taken the advice of some other guys who post here and moved into metals.

So, no I don't give advice, otherwise I'd have my own little column on investing. Seriously, everybody is different with different needs and levels of risk they can take. But you knew that. That's why for folks who like the fund idea, Dan's advice is great. It's just not the only way to go.