The New Rules for Smart Investors: Ignore Them at Your Peril

Every year, Dalbar, Inc., a respected independent market research firm, publishes a study entitled Quantitative Analysis of Investor Behavior. The study measures the actual performance of stock and bond investors and compares that performance to various benchmarks.

The latest study found that, for the 20 year period ending December 31, 2007, the average stock mutual fund investor earned a paltry 4.48% annualized.

The S&P 500 index earned 11.81% during the same period.

Fixed income investors did worse. They earned only 1.55% compared to 7.56% for the Lehman Aggregate bond index.

When you factor in inflation and taxes, both stock and bond investors lost money over this 20 year period.

Clearly, these investors were not well served by their market-beating brokers and advisors, who invested their assets in actively managed stock and bond mutual funds.

Apart from their inability to add value to their clients, the securities industry has been enmeshed in a series of appalling scandals, including analyst fraud and the current auction rate securities debacle.

Smart Investors need to take notice of these irrefutable facts and adopt new rules for protecting their nest eggs. Here are my suggestions:

1. Don't do business with any investment advisor who will not agree in writing that she will act in a fiduciary manner in her dealings with you. This is not just a matter of semantics. By agreeing to this standard, your advisor must place your interests first. She can have no conflicts of interest, disclosed or otherwise. I am amazed at the otherwise sophisticated investors who permit their life savings to be entrusted to advisors whose primary obligation is to their firms. It should be to you--and only to you.

2. Don't do business with any investment advisor who does not focus on your asset allocation and on investing your assets in a globally diversified portfolio of low cost index funds, passively managed funds or ETFs. Unless you want to be a statistic in the next Dalbar report, you need to rid your life of advisors who tell you they can pick stocks or fund managers who can beat the markets or that they can time the markets.

3. Don't do business with any investment advisor who cannot compute the risk of your portfolio using standard deviation and explain to you why your risk is appropriate for your investment objectives and risk tolerance.

4. The overwhelming data indicates that the bond markets are as random and efficient as the stock markets. If your investment advisor suggests an actively managed bond fund, look for another advisor.

5. Don't fall for the laddered bond pitch. I know the data indicating that, over time, a properly constructed laddered bond portfolio may outperform a properly diversified portfolio of mutual bond index funds. Here is what the data does not tell you: The assumption is that you can find an advisor who can properly structure and monitor such a portfolio. Whoever you find is unlikely to be as sophisticated as the fund manager of a mega-billion dollar bond index fund. It is more unlikely she will be able to purchase bonds as efficiently as these fund managers. Even if she is, there is no way your personalized portfolio can be as diversified as the index fund portfolio. A relatively small default can obliterate the benefits of your carefully crafted strategy. Recent events have taught us to expect the unexpected.

There is a more fundamental reason to avoid these portfolios. It may cause you to rely on an industry that has demonstrated repeatedly that it is not worthy of your trust. You will have to spend meaningful time checking and double-checking their work and examining their fees. If you have better things to do, the cost of the loss of this time could be substantial. It is never figured into their projections.

When you consider all the factors, for most people, the extra projected returns from a laddered bond portfolio over an appropriate portfolio of bond index funds is simply not worth the hassle and uncertainty.

Those are the new rules for Smart Investors. Ignore them at your peril.

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.

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Comments

[MadeinAmericaProud]

thank you for taking the time to share the information. Excellent information.

I am small time 401K in holding with fidelity (in between job) I also purchase an investors dictionary blue cover with over 5000 investment words.
I don't the average American have any idea if they had to work a private soc security account.

Again thank you, I do value your time.

[cylindar]

I have a better idea. Invest in yourself and start your own business. That's what I did and I am getting a better rate of return than any market could ever do for me considering the amount of money I had available. Even if someone invested their savings into a small side business that was a part time venture they would make a better return than the market could provide. Just don't go into Real Estate at the moment unless you can wait around for a while like the Maytag repairman.

[fiduciary]

I always was under the impression but not certain that the Dalbar studies measured the results of self-directed investors, who did not have the restraining effect of an advisor to cousel against emotional reactions--selling at the bottom out of fear, or buying at the top out of greed. Is the author saying that the studies includes results of investors who are working with an advisor of some kind?

[Dan Solin - Huffpost Blogger]

The Dalbar study measures the results of all investors, both those that use brokers and those who don't.

There is a compelling study that compares the returns of investors who invest with and without brokers or advisors. It is entitled: "Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry', by Daniel Bergstresser of the Harvard Business School, John M.R. Chalmers of the University of Oregon and Peter Tufano, also of the Harvard Business School. You can download this article at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=616981.

The study found that investors who did not use brokers or advisors did significantly better than those that do.

So much for the "restraining effect of an advisor to counsel against emotional reactions." The study supports the opposite conclusion. In order to generate fees and commissions, brokers and advisors encourage chasing fads and performance.

[robinhood2]

Don't expect a "fiduciary" commitment from a stock broker. I doubt that any broker would commit to such a policy in writing.

My bond portfolio has done substantially better than 1.55%. Most of my positions were buy and hold. Two blocks were sold early for credit reasons, but I was not happy with the bids. Retail investors should not try to actively trade their bonds because of wide bid-ask spreads. You can't place a limit order to sell your muni bonds.

Bond yields are not at all attractive right now vs. inflation.

If you don't understand no load mutual funds or how to invest through a discount stock broker, keep your money in an FDIC-insured bank account. The returns won't be very good and will probably be negative after inflation and taxes, but that's the penalty for being ignorant about the markets. Always stay away from high cost variable annuities. Chances are you won't understand the high fees you are paying, the returns will be lousy and only your broker will be happy.

[Dan Solin - Huffpost Blogger]

You are correct that few brokers will agree to acting as your fiduciary. However, every Registered Investment Advisor is required to be a fiduciary.

Understanding no load mutual funds and investing through a discount stock broker will not assist investors in achieving market returns.

Understanding asset allocation and implementing a globally diversified portfolio of low cost index funds will.

[passosella]

From what I understand, RIAs have conflicts of interest with their clients but must disclose them on an ADV form:
"The SEC’s amendments to the Part 2 are intended to require investment advisers to provide regulators and clients with a brochure written in plain English. The brochure must describe the investment adviser’s services, fees, business practices, and conflicts of interest."

Also, an RIA has said this: "I am a Registered Investment Advisor (RIA) with the Securities and Exchange Commission. Are you impressed? Don’t be. Just about anyone can become an investment advisor. Simply send in a form to the state or federal government with a modest filing fee, and you can join the club. You don’t need an MBA or a college diploma to apply. Heck, you could have flunked out of the third grade, gone bankrupt seven times, lost everything you ever owned to a Ponzi scheme, and still make a great living managing other people’s money."

So, how would an RIA even know what is in the client's best interest?

After MUCH research I have come to the conclusion that 'fiduciary' is just part of the huge scam the investment industry is pulling on it's clients.

Thanks for your article...very interesting.