I am going to give you some advice that could mean the difference between an “enjoyable” retirement one day and a “just get by” retirement. In this post, I will share with you principles that will really make a difference and keep you out of the kind of trouble even “sophisticated” investors find themselves in. If you heed this advice, you will never have to worry about getting fleeced by some crook like Bernie Madoff, the broker who ran a ponzi scheme that allegedly stole around $50 Billion from both institutions and individuals.

So, here goes:

Principle #1. The Stock Market is Efficient. If you get this, you will protect yourself from all kinds of scams and flim-flam artists. What does it mean? In simple terms, it means that no one, no money manager, no market guru, no hedge fund manager, no one, can, over time, beat the stock market returns . . . . period! I don’t care what TV show or radio show they are on. I know I will get all kinds of grief over that statement, but the academic studies (not Wall Street marketing departments) are on my side – or actually, I am on their side. Every statistically significant study I know of, and I have read a lot, substantiates this position.

So, what does this mean for how you should invest your IRA money? It means, do not use “active managers.” Active managers are those money managers who believe they are smarter and better than the markets and all the rest of the professional investors and they can pick the right stocks and time the markets correctly so that they can produce superior returns over the markets. Don’t buy into this hype and you will stay away from the ego maniacs, scam artists, flim-flam artists and the misguided and well meaning investment advisors who have drank the cool-aid of active management. Instead, if you are a do-it-yourselfer, stick to broadly diversified, low cost Index Funds, broadly diversified Exchange Traded Funds (ETFs). Use an inexpensive discount brokerage firm to hold your account.

If you are not a do-it-yourselfer, hire a fee-only registered Investment Advisor who uses passive low cost asset class funds only – like funds by Dimensional Fund Advisors (DFA) or Vanguard Funds. Usually, the total cost of investing with these kinds of advisors will be less expensive than just the internal cost of active funds, so paying a fee-only advisor will generally still cost less than using actively managed funds before you pay the advisor. This is definitely the case with the firm I work with.

All active managers introduce more risk into your portfolio than passively managed asset class funds – it is called non-systematic risk. You don’t get compensated for non-systematic risk, so why take it?

All active managers add more costs to investing than passive investing. These costs are not revealed in reports or the prospectus. You can estimate the difference by looking at the “turnover rate” of the portfolio: the higher the turnover, the higher the cost. With broadly diversified stock funds, the turnover rate should usually be less than 10%.

Active managers add costs and risks and generally underperform their passive counterparts, so why use an active manager? It doesn’t pay and, after all, isn’t that what you want your IRA investments to do. . . . pay?

For those who want to do more research on this issue of the stock market being efficient, do a Google search on Efficient Market Hypothesis and Professor Eugene Fama of the University of Chicago Graduate School of Business.

Principle #2. Diversification is Key The way to consistently win is to hold very broadly diversified, global, low cost, asset class mutual funds. Diversification reduces uncertainty. If you hold a mutual fund of US securities with about 3500 stocks in it and one of them happens to be a Bear Stearns or Lehman Brothers, it will hardly make a blip in your portfolio as it goes out of existence. Don’t be caught with concentrated position mutual funds or with individual securities. You will be carrying too much risk that you can diversify your way out of.

Stock pickers and market timers will tell you just the opposite. They will say you should pick the particular asset classes or stock industry groups that will outperform in the next time period and either buy funds specializing in those groups or buy individual stocks in those groups because “it is a stock picker’s market.” One significant problem with that approach is not only that you will need to know  which stocks of funds to buy in advance of their performance, but you will also have to know when their “time” in the sun is over and dump them before you give back your predicted gains. So now, you have to be right twice. When you look back at Principle #1, it becomes obvious that “concentrated positions” that are determined by stock pickers or market timers are foolish for a long term investor. Owning a concentrated portfolio does hold the possibility of outperforming the market, but it does so at a risk level generally not understood nor appreciated. Most who try concentrated portfolios fail.

Principle #3. Risk and Return are Related. Exposure to meaningful risk factors in a diversified portfolio determines expected return. Over the long haul, stocks outperform bonds but not always; over the long haul small stocks outperform large stocks, but not always; over the long haul value stocks outperform growth stocks, but not always. Each of these outperformers has a greater volatility risk and a greater expected return.

The table below shows the Annualized Compound Returns as well as the Annual Average Returns for both domestic and non-US stocks for periods as long as we have reliable data. This data supports my contention that small and value stocks outperform over time and that it applies to the whole world of stock investing.

 

sizeandvalueeffectsarestrongaround-theworld

For a larger image, click the image twice.

 

Principle #4.Portfolio Structure Determines Performance. Asset allocation along size, value, and market exposure dimensions primarily determines the results of a broadly diversified portfolio. In other words, to increase the expected return of your portfolio, own low cost, globally diversified asset class mutual funds that are over weighted to smaller and more value oriented stocks. If an all stock fund portfolio is too volatile for you, add some short term high quality bond funds to damper the volatility.

Following academically sound investment principles will allow you to win the losers game. Don’t give in to the Wall Street marketing gurus who have proven their ability to separate you from your money, quickly and permanently.

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