THE BLOG
09/02/2008 10:23 pm ET Updated May 25, 2011

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.