03/26/2008 10:41 am ET Updated May 25, 2011

Smart Advice for the HuffPost Investor: Everything You Wanted To Know About Investing and Had The Courage to Ask!

I write this column for "responsible investors": Hard working Americans saving for retirement or for their children's education.

I have nothing against those who want to speculate with their assets. However when speculators regale us with reports of outsized returns, it is important to challenge them for several reasons.

First, if they have discovered the holy grail of investing--big returns with little risk--we should all know about it and benefit from it.

Second, if their reports do not withstand scrutiny, we should know about that as well, so that investors are not deceived into believing that there really is a free lunch.

In my last column, I challenged a reader who reported that he had achieved returns of 32% a year for the past ten years. His system was simple. He stated that he "...pretty much followed the Motley Fool recommendations..."

When confronted with conflicting facts, he responded that he had neglected to mention that he also used "...the advice of another 'stock picker' you may know to help keep my fundamentals sound; his name is Warren Buffett and he seems to do ok."

His response stimulated a spirited discussion and many questions.

In order to deal with as many issues as I can that were raised in the ensuing dialogue, I am going to change the format of this week's column. I will ask myself questions reflecting your concerns and then answer them.

Let me know how you like this format.

Please continue to add your views and questions as comments to this blog. I find all of them helpful and thought provoking.

Question: What's wrong with relying on the "stock picking" advice of Warren Buffet?

Answer: Warren Buffet does not engage, or believe in, stock picking. He typically buys companies or plays an active management role as a member of the Board of Directors of the company in which he invests. His advice to investors is to buy index funds. Here is a quote from his 2007 Chairman's letter:

But this group [active investors] will incur high transaction, management and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group--the 'know nothings'--must win.

My advice to investors mirrors Warren Buffet's.

It is interesting to note that the compounded annual gain of Berkshire Hathaway stock from 1965 to 2007 was 21.1%, which is significantly less than the gain reported by the reader who says he relied on Warren Buffet's "stock picking" advice.

Question: You are always talking about the difficulty of "beating the market." What does that mean?

Answer: "Beating the market" refers to the efforts by investors to obtain higher returns from their portfolios than they would be able to achieve by purchasing an index fund that had a comparable level of risk.

Most investors do not know how much risk they are incurring with their portfolios, so they are unable to determine the benchmark or index to which it should be compared.

Question: Why do you fail to acknowledge the fact that many investors and funds are successful in "beating the markets"?

Answer: I don't. Every year, approximately one-third of all mutual funds beat their benchmark. Over a ten year period, only about 5% of them are able to do so.

There have been some notable exceptions. Bill Miller, who manages the Legg Mason Value Trust Mutual Fund, beat his benchmark for 15 years in a row. However, by the end of 2007, the three-year annualized returns of the fund he manages were 3.64 percentage points below the S & P 500.

My point is not that beating the markets is impossible. It is that it is a negative sum game when you consider the costs and the significant odds against achieving this goal over the long term. I have yet to see any peer reviewed study indicating that success is based on skill rather than luck.

Question: Why isn't the formula for investment success to buy "good companies" and stay focused on fundamentals?

Answer: To paraphrase Bill Clinton, it depends on what your definition of "good companies" is. Companies with good fundamentals or companies that yield superior returns?

As I noted in a previous blog, the stocks of poorly managed companies, with bleak prospects, have historically outperformed investments in well-managed, financially healthy, companies over the long term.

In addition, it is somewhat naïve of investors to believe that they can find mispricings in the market when thousands of highly paid analysts are scrutinizing all publicly available information about every stock.

Finally, if there was a system that permitted outsized returns by analyzing stocks in a certain manner, or by following a well-defined methodology, it would be published in a peer reviewed journal like The Journal of Finance.

There is no such published study. That should tell you something.

Question: If I had listened to you, I would have been long in the market and lost money this year. How do you explain that?

Answer: Not true. If you had listened to me you would have determined an asset allocation appropriate for your investment objectives and tolerance for risk. If you concluded that the risk of any loss in the market for any period of time was unacceptable, you would not have invested in the market. Instead, your portfolio would have been in CDs, Treasury Bills or a short term bond index fund.

If you determined that you could withstand some market risk, you would have incurred losses so far this year, but you would understand that the market has risks and that short term volatility is one of those risks. You would be prepared to hold on for the long term and would not turn unrealized losses into realized ones.

Question: Your investment advice seems to ignore the dire straits that our economy is in. Why?

Answer: My investment advice is that investors should determine their risk level and invest in a globally diversified portfolio of index funds. These portfolios can range from very conservative to very aggressive.

I do not have the ability to predict the future of the economy and make no judgment -- positive or negative -- about the direction of the markets. I can find no data indicating that anyone has this ability.

I understand that some readers believe we are headed towards financial Armageddon. I don't know if they are right or wrong. If they believe this is the case, they should not take any market risk. Of course, if they are wrong, they will be taking meaningful inflation and tax risks.

Question: How should investors protect themselves from a falling dollar?

Answer: Some readers believe that the dollar will keep falling "for another ten years." These predictions are very unreliable. I am opposed to currency speculation because of its inherent risk. For example, if it is true that the dollar will keep falling, what currencies would be a better investment: China? India? The Euro? How would you make that determination?

I have advised investors to have a globally diversified portfolio and to invest 30% of the stock portion of their portfolios in international stocks, using low cost index funds like Vanguard's Total International Stock Index Fund (VGTSX) or Fidelity's Spartan International Index Fund (FSIIX). For the bond portion of your portfolio, I have recommended that investors have 50% invested in foreign bonds. The SPDR Lehman International Treasury Bond ETF (BWX) would be worthy of consideration. Other foreign bond funds include the Oppenheimer International Bond Fund, unhedged (OIBAX), the Templeton Global Bond Fund, hedged (TPINX), the Alliance Bernstein Global Bond Fund leveraged, un-hedged (ANAGX) and the T. Rowe Price International Bond Fund (RPIBX).

Dimensional Fund Advisors has passively managed, foreign bond funds (which are part of my personal portfolio and in which I place my clients). These include the DFA Two Year Global Fixed Income Index Fund, and the DFA Five Year Global Fixed Income Index 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.