Time for a Reality Check

(from Dan Solin's Huffington Post blog, 10/28/2010 - click here for the original post)

As year-end approaches, this seems like a good time for a reality check.

On October 9, 2007, the Dow Jones Industrial Average closed at its all time high of 14,164. At that level, it had gained 94% over the preceding five years. The euphoria of the bulls was palpable.

On March 9, 2009, the index reached a new twelve-year low, closing at 6,547. The bears became the talk of Wall Street. Doom was in the air.

How you dealt with your investments during this period is indicative of everything that is wrong with the securities industry and why you need to fundamentally change the way you invest.

Few brokers predicted the greatest financial crisis since the Great Depression. Almost no one predicted both the meltdown and rapid recovery of the markets. Yet more than 90% of individual investors maintain brokerage accounts and rely on the flawed advice of their "investment professionals."

What if you didn't panic and did nothing from October 9, 2007 to date? I call it the Seinfeld approach to investing. You were in a globally diversified portfolio of low cost index or passively managed funds in an asset allocation (the division of your portfolio between stocks and bonds) appropriate for your tolerance for risk and investment objectives.

As of September 30, 2010, if your allocation to stocks was 50%, your portfolio has fully recovered. Investors with with an allocation of less than 50% to stocks have positive returns. If you were among the small percent of investors for whom an allocation of 100% stocks was appropriate, your total return is down almost 20%.

Check your portfolio returns. How do those results compare? Most likely, not well if you were listening to the financial pundits and "fled to safety" when the market crashed.

Almost all clients of brokers invest in actively managed funds, where the fund manager attempts to "beat the market." The use of these funds is another reason why investors typically underperform the market. If there is one compelling reason for terminating your relationship with your broker, it's the fact that recommendations of actively managed mutual funds are the way brokers make a living.

In a recent blog, Eugene Fama and Kenneth French, two of the most distinguished Professors of Finance in the country, explained the folly of investing in actively managed funds. They concluded that, when you factor luck into the equation, they expect 97% of actively managed funds to underperform a passive alternative.

Their conclusion is consistent with other studies that have shown over 99% of active fund managers have no genuine stock picking ability.

If your personal reality check persuades you to enter the New Year with a new investing approach, don't necessarily assume you can do it yourself. Studies over a 30 year period show that even those who pursue an indexing strategy on their own fail to capture 100% of market returns. They still do far better than investors in actively managed funds, but their failure to rebalance their portfolios and the lack of discipline to stay the course when times get rough, take a heavy toll.

A competent passive advisor, who focuses on your asset allocation and recommends investments only in index funds, passively managed funds or Exchange Traded Funds, can be a wise investment.