In these times of low interest rates and volatile stock returns, wouldn’t it be nice to earn 2 percent or more per year with no extra risk? Of course it would! You can do it in 3 easy steps.
Academics have been promoting these ideas for decade. Their recommendations are robust, conclusive, and…crushed by Wall Street’s annual multi-billion dollar marketing effort.
Most recommendations perpetrated by Wall Street firms are designed to make money from you, not for you. They base their ideas on how much profit they earn – not what you earn. Ignore the noise. Let the markets work for you. Follow these 3 steps and learn how to boost your bottom line:
Step 1: Don’t attempt to time markets or sectors
Wall Street experts have less ability to predict the markets than flipping a coin. The average expert is right only about 48 percent of the time, according to forecasts collected by CXO Advisory. Investors would be better off ignoring market advice and staying invested in an appropriate fixed asset allocation.
Analysts who try to predict the next winning industry fare no better than those who try to time the overall market, according to economist Fritz Meyer. Over the past three years, the ratio of wrong industry calls to correct industry calls has been about 2 to 1, meaning for every good call there have been two bad ones. These are supposed to be the industry experts!
Investors who attempt to time markets or rotate sectors have lower portfolio returns in the aggregate. Morningstar found that investors have underperformed the funds they invest in by about 1.5 percent per year during the last decade. This occurred because fund investors tend to buy into investments when prices are high and sell when prices are low – exactly the opposite of what they intend to do.
Step 2: Dump high cost mutual funds that try to beat the markets
Given the dismal record of experts at timing markets and picking sectors, it’s no surprise that most mutual fund managers who try to beat the markets have also failed miserably. The Mid-Year 2012 S&P Indices versus Active Funds Scorecard (SPIVA) again shows indexes beating actively-managed funds in almost every asset class, style and fund category. This is a consistent trend.
The only exception to the mid-year 2012 SPIVA report was international equity. Actively-managed funds outperformed the index that S&P selected as a benchmark. However, this doesn’t mean international equity managers will win in the future. There are always one or two categories in any SPIVA report that show active mangers beating their benchmarks, but it doesn’t last. Next report it will be another random category that outperforms.
The culprit of poor active fund performance is high cost. Research needs to be bought, analysts need to be paid, staffs need year-end bonuses to stop from jumping to other firms, and over-sized profits need to be made by company owners – all resulting in lower returns to investors. The average active equity fund has expenses totaling about 1.1 percent per year while comparable index funds have fees averaging 0.2 percent according to Morningstar data. In addition, the turnover inside active funds is very high relative to index funds and that increases the tax burden for taxable investors.
Step 3: Invest in an index fund portfolio using a buy, hold and rebalance strategy.
Index funds track the performance of markets and charge very low fees. Wise investors select different index funds and exchange-traded funds (ETFs) based on their needs and hold them long-term. These portfolios are occasionally rebalanced to maintain a fixed asset allocation. I provided details in All About Index Funds, The ETF Book and All About Asset Allocation.
Academic studies discussed in The Power of Passive Investing find that portfolios holding only index funds beat portfolios holding actively-managed funds 95 percent of the time over a 10-year period. In addition, the longer you hold an all index fund portfolio, the greater your advantage. Actively-managed funds simply cannot keep pace.
There may be a fourth step taken by people who use an investment adviser or broker to manage their portfolios. Skilled advisers will agree wholeheartedly with everything I’ve written. Unfortunately, there is a severe shortage of skilled advisers. More often an adviser will charge 1.0 percent or more in fees to try to time markets and select funds they think will beat the market. Save yourself money and fire these advisers. Either do it yourself or find a low fee adviser who believes in index funds and non-speculative portfolio strategies.
In summary, there are 3 steps separating you from higher returns. Stop buying actively-managed mutual funds that have high expenses, forget trying to time markets or sectors, and invest in an all index fund portfolio that’s tailored to your needs. Finally, unskilled advisers will object. Dump them and save more money. It’s that simple.