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

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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

2008-04-30-Picture6.jpg

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.