THE BLOG
11/29/2011 07:53 pm ET Updated Jan 29, 2012

Their Confidence Is Killing Your Returns

What do these well known financial celebrities have in common: Jim Cramer, Larry Kudlow, Jeff Macke, Joe Kernan and Dylan Ratigan?

They are all extremely confident. There is little personal vulnerability in their presentations. They provide their views on the economy, attempt to pick stock "winners", engage in marking timing predictions and anoint the next hot mutual fund managers unequivocally and with self-assurance.

Many brokers and advisors, who engage in the same activity, share this trait of uber confidence. Here's a typical example I recently encountered.

At the request of a prospective client, I proposed a risk adjusted portfolio, consisting of low management fee, passively managed stock and bond funds. I tilted the portfolio towards small and value stocks, consistent with the research of Eugene Fama and Kenneth French. Their research explained the relationship between risk and return for stocks. It is known as the Fama-French three-factor model. Distilled to its essence, the Fama-French three-factor model holds that a portfolio tilted toward small and value stocks (which increases risk) has a higher expected return than a portfolio without this tilt, over the long term. You can read more about the Fama-French three factor model here. In my recent book, The Smartest Portfolio You'll Ever Own, I recommended portfolios of index and exchange traded funds at different risk levels that investors could implement themselves. These portfolios are based on the research of Fama and French.

My prospective client showed my recommendations to a friend who is a well-known financial advisor. He derided them as "possibly" suitable for those who wanted to preserve wealth, but not to grow it. In order to grow wealth, he advised retaining his firm because of its ability to time the markets and "customize an individually tailored portfolio of stocks and bonds."

The research supporting my recommended portfolio is extensive and is summarized in the bibliography to my book. His advisor friend provided no research validating his approach to investing, but he made up for the lack of data with his air of infallibility and aura of expertise.

I often wonder why so many investors ignore the overwhelming data indicating that capturing market returns in a globally diversified portfolio of low management fee index funds in a suitable asset allocation is likely to outperform stock picking, manager picking and market timing -- the daily grist of many brokers and advisors. If you have limited time for research on this subject, take a look at the "Standard & Poor's Indices Versus Active" reports, which you can find here.

The answer to this riddle may have nothing to do with a battle over data, and everything to do with the perception of confidence. Don Moore, of Carnegie Mellon University, conducted research showing that we are inclined to accept advice from a confident source, even if the track record of that source is unworthy of our trust. Another study is even more troublesome. It found those receiving "expert" advice essentially "switched off" their brains (as measured by an MRI). The subjects would have been better off ignoring the advice of the "experts" and making their own decisions, but their brains went "dormant" when confronted with "expert" advice.

Keep this research in mind the next time you are exposed to the oh-so-confident opinions of financial experts. You would likely be better off independently looking at the data and making your own decision.


Dan Solin is a Senior Vice-President of Index Funds Advisors (ifa.com). He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.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. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.