Some Depressing Facts

The difference between investing intelligently and unintelligently can mean the difference between a comfortable retirement and an uncomfortable one.  Unfortunately, the way many people invest--hiring an average investment advisor and picking a few stocks and funds--is often not intelligent.  Instead, it is often risky, random, and expensive.

Most Americans wouldn't dream of buying a car by walking into a dealership, accepting every option and extra recommended by the salesman, and then happily paying the quoted price with no questions asked.  When it comes to investing, however, this is exactly what many people do. 

The best way to ensure that you invest intelligently is to know as much as you can about the source of investment returns, common investing mistakes, and the strategies that give you the best odds of success.  To start, here are some depressing facts:

• The average mutual fund is so expensive (1.5% of assets per year) that it will likely cost you nearly half of your potential retirement nest egg over 50 years.

• The cost of the average mutual fund combined with the cost of the average financial advisor will likely vaporize about two-thirds of your potential retirement nest egg over 50 years.

• The odds that you will beat the market over the long term by trying to pick "superior" stocks or funds are between 1-in-4 and 1-in-40.  The chances that you will hurt your returns by picking stocks, therefore, are between 75% and 98%. 

• If you are lucky (or skilled) enough to beat these long odds and the market, you will be rewarded with "excess" returns of 1%-2% per year.

• If you are not lucky enough, you will be punished for your failure with a return that lags the market by 2%-3% per year.  (Assuming you stick with the lousy stocks and funds.  If you sell them and try to buy better ones, as most people do, your return will likely be much worse.)

• The average hedge fund is so expensive that, for a taxable investor, the fund must post a 20% gross return to deliver the same net after-tax return as a low-cost index fund with a gross return of 10%.  (Most people ignore tax costs when raving about fantastic hedge-fund returns.  For a pension fund, this is smart, because pension funds don't pay taxes.  For a regular old taxable investor, it's delusional).

• The average hedge-fund fund-of-funds is so expensive that, for a taxable investor, the fund must post a gross return of 24% to match the net after-tax return of an index fund with a gross return of 10%.

• The apparently amazing returns of most star stockpickers are not the result of stock-picking skill but exposure to various risk factors (such as stock size, stock value, and stock momentum).  In most cases, these investors would have done better if they had just bought and held index funds with the same "factor" exposure.

• Most mutual funds get paid millions of dollars a year to subtract value.  One reason the mutual fund business is such a great business is that most mutual fund customers don't know or care.

• The only part of your investment return that you can directly control is costs.  (So don't be like the average boob, who ignores them).

• The standard P/E ratio is nearly useless as a near-term market prediction tool. (According to a correctly calculated P/E ratio, the U.S. stock market has been "overvalued" since 1986.)  The same goes for interest rates, changes in interest rates, and the "Fed Model."

• If you predict that the stock market will go up, your odds of being right are about 2-in-3.  If you predict the stock market will go down, your odds are about 1-in-3.  These odds don't change much from year to year. 

• The idea that a part-time amateur with an Internet connection and an e*Trade account should expect to out-trade a full-time hedge-fund manager with a $20 million annual research budget, a Rolodex full of industry and management contacts, and years of professional experience is, sadly, preposterous.  It is, however, common.

• The source of most investor returns is the market, not the investor's decisions.  Most investors reduce the returns they would have generated if they had just diversified their assets and let the markets do the work.

• The most intelligent investment strategy for most investors is to buy low-cost, passively managed index or "lifecycle" funds, such as those offered by Vanguard.

Comments

[Matt]

I've been telling people for a while now that financial investment strategy is the opposite of sex-- if it's exciting, you're doing it badly. Good to see someone else joining Team Dull.

[Jake]

Thank-you for saying the same thing that I have been saying for years (although you do it a bit better). The key is not in having the intelligence, but in having the stomach to stick with a simple, low or no cost plan, and ride it out.

Unfortunately, I have several family members who would be in much better positions, financially, if they had read this / listened to me 10 or 15 years ago than they are now. They still try and pick individual stocks: often knowing little, if anything, about the company itself.
Finally, your recent post on Slate.com is excellent, and should be required reading for high school and college seniors before they accept their first jobs.

[Him]

Thank you for your timely post. I just read your adapted excerpts from your book today on Slate.

My fiancee and I are currently in the middle of figuring out our retirement asset allocation (as you can see on our blog). Everything you've stated is how we're going to do things. Hopefully we can get things right.

[fCh]

Most our economy works through agents whose purpose is to generate action--not inform, not educate, not make money for you for if they could make money they would do it for themselves.

We don't trust the agents. say, in a car dealership so we learn a fair amount about cars each time we go and buy one. However, learning about cars is somehow an easier process than learning about financial markets. So, in the end, we still end up listening to financial markets' agents, even if only to know in what index funds to put our money.

Then, the next thing you are going to tell yourself may well be: "I know these guys are crooks, but look at how rich I would have gotten had I listened to him/her; Yeah, I may not be able to fix the world, but if I get once lucky I am done."

And from here it goes downward.

Why isn't anyone saying something about the responsibility SEC should bear for its oversight shortcomings in the late nineties? Not to mention it took Mr. Levitt (SEC Chairman) until retirement to tell us, in a book, how bad the situation was...

[Zhenwei Chan]

Hi, I just bought a copy of the Wall Street Self Defense Manual. I have to admit it turned the tables on a lot of conventional wisdom. Still, i have one nagging question: If most hedge funds and mutual funds lag behind their benchmarks, why are so many people still buying them? Especially the high net worth individuals? They can't be that dumb!