THE BLOG
08/06/2013 06:47 pm ET | Updated Oct 06, 2013

Test Your Investing IQ

For the period ending July 31, the two- and three-year return of the Russell 3000 index was 16.69 percent and 18.09 percent. This index is generally considered to be a good benchmark for the returns of the U.S. stock market. It's easy to capture the returns of this index, and iShares offers an exchange-traded fund (IWV) that tracks the Russell 3000. IWV has an expense ratio of 0.20 percent, and it was up 13.94 percent year-to-date through June.

I am not suggesting you put all your assets in funds that track this index. Instead, you should invest in a globally diversified portfolio of low-management-fee index funds in an asset allocation suitable for you. I use the returns of the domestic stock market to make this point: Index-based returns are yours for the taking. The vast majority of investors are not getting them because of bad investment decisions caused by lack of knowledge. This series of questions and answers about investing may help you change the way you invest and improve your returns:

Q. You go to a broker. You are 40 years old. You want a portfolio of mutual funds. You are a long-term investor, interested in saving for retirement. The broker recommends 10 equally weighted, actively managed mutual funds. What are the odds that these funds (rebalanced annually) will beat their benchmark over a 10-year period?
A. 0.055 percent.

Q. What are the odds of the funds recommended by the broker surviving the 10-year period?
A. About 51 percent will survive. Historically, funds that don't survive are typically victims of poor performance.

Q. The broker recommended the portfolio of mutual funds based on stellar past performance. Is that a good indicator of future performance?
A. Standard & Poor's measured the performance of funds for the five years ending March 2013. Less than 5 percent of large, midcap and small-cap funds were able to maintain their top-half performance for five consecutive years.

Q. Would the broker have been better advised to look at some other factor to determine which mutual funds were likely to outperform in the future?
A. Yes, studies consistently show that low expense ratios are strong predictors of better performance.

Q. Why don't most brokers recommend index funds with low expense ratios?
A. Because it is not in their financial interest to do so.

Q. Does my broker have to act solely in my best interest in making recommendations?
A. No. Your broker is not a fiduciary to you. He or she can recommend funds that meet the lower standard of "suitability," even though there are funds available with lower costs and higher expected returns. That's why brokers can get away with recommending proprietary mutual funds instead of comparable index funds. All Registered Investment Advisor firms are fiduciaries to their clients.

Q. What if my broker was as skilled as managers of public pension funds? Don't they have the ability to pick outperforming actively managed funds?
A. Studies of public pension plans show their returns underperform comparable indexes in similar asset allocations.

Q. How much does chasing returns using actively managed funds cost investors every year?
A. $80 billion.

Q. I have read that 80 percent of investors buy actively managed funds. It appears they are making a critical investment mistake. How can this be?
A. They don't know the data. They are misled by financial media and influenced by the huge marketing machine funded by the securities industry. They also believe watching CNBC is helpful to "understanding the markets"; that Jim Cramer and other pundits have some special insight into the future that is worth hearing; and that predictions about interest rates, market direction and the future of the economy -- when made by seemingly credible sources -- have value. None of this is supported by credible evidence.

Q. Would I be better off investing in an startup company that is raising venture capital?
A. You typically hear about the big winners. What isn't as well known is that around 75 percent of venture-backed firms in the U.S. fail to return to investors the amount of money invested in them.

Q. My broker tells me he can pick stocks, time the market and pick fund managers likely to outperform. What should I say to him?
A. Goodbye!

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.