Rules of the Game: Using What Works

 | Jul 22, 2013 | 2:00 PM EDT
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I've been writing lately about the folly of trying to "beat the market." While many investors understand the underpinnings of the Efficient Market Hypothesis, others continue to have unrealistic expectations of how their portfolios should perform.

Sometimes when I talk to people who are vaguely dissatisfied with their portfolios -- even though their investments are showing gains -- they imply that they want more. How much more? They usually can't say. They know it's ridiculous to say, "I want my money to double in six months!" (Though the peddlers of trading systems will never disabuse anyone of such a notion.)

Too often people for whom a conservative portfolio is appropriate expect to receive growth that would be commensurate with a much higher level of risk. In other words, they want what would be an inappropriate level of risk for people who primarily need to preserve capital.

Sadly, too many investors believe they have to scour Morningstar data to find a better fund manager, or that they can trade on their own and time the market correctly, leading to eye-popping gains. Never mind that the old cliché that "past performance does not indicate future performance" is true.

And never mind that the vast majority of individual traders don't have any strategy that matches their financial plan, nor do they have an accurate measure of their risk tolerance.

How about just using what works? There's plenty of data to show that passive, or index, investing is a more sensible approach. One immediate way in which passive investing is more efficient: Because active managers (including traders) tend to keep cash on hand for quick purchases, there is less money deployed into actual investments.

Another advantage of passive investing is the ability of managers to allocate various asset classes strategically. Doesn't that sound better than a portfolio that bets only on growth stocks like Proto Labs (PRLB), Lumber Liquidators (LL), Fleetcor Technologies (FLT) or Evercore Partners (EVR), and then goes stampeding into all cash at the first sign of a market correction?

Market volatility has taken a toll on those who have traded in and out, based on various technical indicators. Not only do the costs of trading add up, but it becomes more difficult to correctly time the trades.

Among active traders, the research of William Sharpe is largely unknown. Sharpe demonstrated that active investors will always underperform "the market" as a whole. Why is that? Simple: Because higher costs of an active approach will always add up. I know plenty of trading coaches who will only talk about the gains to be had in individual securities, but dismiss commissions and taxes as irrelevant.

If you prefer actively-managed mutual funds over do-it-yourself hopium, be aware: Only fund manager expenses are disclosed in your statements, and these are frequently complex and hard to understand.

Don't make the mistake of assuming that passive investing is the same as the much-maligned "buy and hold." Passive investing involves rebalancing the asset allocations to keep them in line with your stated objectives. I'll write more on that later in the week.



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