If you're serious about getting better investing results, you essentially have two choices. You can continue to rely on the opinions and recommendations of "experts" who claim to be able to "beat the market," or you can be smart and invest based on sound financial and mathematical principles. Start by absorbing the following facts:
Fact # 1: Most individual investors underperform the market. You are much more likely to achieve better returns1 in a globally diversified portfolio of low management fee index funds, with an asset allocation that fits your age, investor type, and emotional temperament.
Fact #2: You probably believe you are a much better investor than you actually are. You may be seriously overestimating your returns2. You can't fix a problem until you acknowledge it exists. Ask your accountant to run your numbers and you'll see what I mean.
Fact # 3: The fees charged by a mutual fund are a better predictor of future performance than Morningstar's popular star ratings3. In general, the lower the fees, the higher the returns. Even Morningstar itself admits this fact.
Fact # 4: Reliance on forecasts is misplaced. The predictions of so-called market gurus are bad enough. According to William Sherden, author of The Fortune Sellers, even the most credible sources, like the Federal Reserve and the Council of Economic Advisers, have no better track records than you would expect from your uncle Monty.
Fact #5: You are probably ignoring Warren Buffett's advice. Sellers of investment advice love to use Warren Buffett as an example of a great stock picker. Given Buffett's stellar track record, the marketing message is "He can do it and so can you." Seriously? Buffett consistently tells4 investors to use index funds that match the market, rather than trying to guess which active mutual funds will beat the market once you get on board.
Fact #6: You probably aren't a better investor than managers of huge pension plans and college endowments. These investing behemoths have resources not available to most individual investors. They can hire the best and brightest talent from the top schools. They use high-priced consultants to carefully screen the managers of mutual funds before they invest. They pay much lower fees than individuals because of the sheer size of their investment pools.
With all of these advantages, you would think they would have a consistent record of "beating the market." But you would be wrong. A comprehensive study5 of 3,700 plan sponsors over a 10-year period found that plans hired managers based on a track record of market-beating past performance. However, post-hiring returns were "indistinguishable from zero." Do you really believe your broker will have any greater success in picking the next "hot" fund manager?
Fact #7: You probably don't fully appreciate the huge impact of luck on investment results. As Larry Swedroe notes in his book, Think, Act, and Invest Like Warren Buffett, it's not impossible to "beat the market." Many funds and individual investors do so every year. But the odds of beating the market are approximately 1-in-50.
Given the millions of investors and tens of thousands of fund managers, you would expect outperformance by some, due purely to random chance. If there are inefficiencies in the market that can be exploited by financial "experts," then there should be evidence of persistent outperformance beyond what you would expect from luck alone. But there is no such evidence.
A 2007 University of Chicago study looked at the performance of domestic stock mutual funds from January 1980 to December 2006. The author concluded even the "best" mutual fund managers "do not have stock-picking skills." If these managers lack this skill, do you really believe your broker has it?
What You Can Do With These Facts
Understanding these facts should take you a long way in your quest to improve as a serious investor. Here's my recommended action plan:
- Ignore anyone - professional or otherwise - who claims to be able to "beat the market" unless they also admit that they are in possession of a hot tub time machine. Without one, beating the market is simply a matter of random and unrepeatable chance.
- Ignore economic and stock market predictions, no matter who makes them, with the possible exception of Madame Ruth - you know, that Gypsy with the gold-capped tooth. She's got a pad down on Thirty-Fourth and Vine, selling little bottles of Love Potion Number Nine.
- Don't engage in stock picking, or market timing, unless you've convinced yourself that you're smarter than the nuclear physicists and math geniuses who dominate the market today.
- Don't invest in mutual funds that claim to have "outperformed 99% of our peers over the past 1, 3, 5, and 10 years." If you torture a set of performance statistics long enough, they will tell you anything you want to hear.
- Avoid any trading system, seminar, or school that claims it will teach you a foolproof way to beat the market. The only people who buy foolproof products are the fools who believe that they actually work.
Footnotes & Links
2seriously overestimating your returns