Active Investing = Washout

From the Big Picture:

Why Is Active Failing?

• Too much competition: As Charles Ellis, a former member of both the Yale endowment fund and Vanguard’s board (our podcast is here), observed:

Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat market averages.

Hence, even a market that is not perfectly efficient quickly eliminates almost all of the potential alpha, or above-market returns. Being smart, hard-working and savvy may create only a short-lived advantage — or none at all.

• Main Street has given up on Wall Street: The average retail investor over the past 15 years or so has endured the dot-com boom and bust, the housing bubble, a full-blown financial crisis followed by an awful stock-market crash, a whipsawing commodities market and almost zero returns on cash savings. These investors now suffer from finance fatigue and have little interest or faith in anything that Wall Street is selling.

Is it any surprise that many investors, after having been so badly beaten up, have decided to take their ball and go home? And by ball, I mean capital, and by home, I mean low-cost index funds. ...

• Internet has leveled the playing field: How much information that once was the province of a select few is now in the hands of all?

It was a huge game-changer when Yahoo message boards begin to fill up with posts from people doing legwork on individual companies. When someone reported that XYZ Tech’s employee parking lots were filled with cars 24/7 — including weekends — anyone paying attention understood that business was booming and that sales were going to beat investor expectations. For the few who grasped that, this was a period of large trading profits.

This advantage exists only when a small number of people know what a large number of people are going to find out too late to act on. When everyone knows, the advantage disappears. ...

Here and there I get asked by TAG members: "What's the best way to invest? I don't know ANYTHING about investing." ...

This is my answer (verbatim):

I'm not a licensed financial advisor, but I've been involved with TAG's 401(k) Plan and reading and studying the subject for 21 years ... and making investment mistakes for a long time before that. And here is the secret to investing for retirement (or most any other long-term thing) in a nutshell.

* It's really simple. You need three funds -- Total Stock Market (U.S.) Index; Total Bond Index; Total International Stock Index.

You need to put money into these accounts week in and week out, from the time you start earning a living to the time retire. Fifty dollars every payday, two hundred dollars, something. And keep doing that "weekly contribution" through the thin times and the fat times.

That's it.

Oh. And you have to set up your stock/bond allocation.

Do you want to be heavier in U.S. stocks, or lighter? Do you want more bonds? Most people need three stock-bond settings during their lifetimes -- from ages 25-45, it should be 60% stocks and 40% bonds (with international somewhere between 30%-40% of the stock portion); from 45-60 it should be 50% stocks/50% bonds. And from 61 to pushing up daisies time it should be 60% bonds/40% stocks. ...

Now obviously the above is Hulett's take on "How To Invest". Your Aunt Miriam might swear by a 50%/50% allocation from start to finish, and there is nothing wrong with that.

And if you have more than enough loot to last the rest of your lifetime, you can take yourself out of the "risk" game by stashing most of your money in bonds and Certificates of Deposit, although Vanguard's Portfolio Allocations Graphic shows that 80% intermediate bonds, 20% stocks is the last risky of any allocation.

But here's what louses up most investors: No matter how carefully you construct a "just right" stock/bond portfolio, no matter how fervently you tell yourself you'll be able to stick with your custom-build allocation, many investors freak out when their stock investments head south and flee from their carefully-thought-out stock and bond models, thereby "selling low" and getting crappier returns over the long haul.

The trick is, either have a cast-iron stomach and ignore plunging assets in your accounts, or forget you have those accounts altogether. (Simple, no?)