Seven Shocking Tips to Boost Your Returns by 400% (or More)

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This is the time of year when the financial pundits come out in droves with predictions about the stock market and the upcoming year's winners and losers. Unfortunately, all of the crystal ball-gazing can cause a lot more harm than good to an investor's portfolio.

%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%%What these "pros" don't talk about on CNBC are the truly valuable studiesout there that would have investors approaching their investments in a much different manner if they were privy to them.Below are seven investing tips for the new year that some may find shocking. These counter-intuitive tips are based on hard, irrefutable data. Once you understand how to implement them, you could be on the way to increasing your returns by 400% or more.

Shocking tip #1: Fire your broker and close your retail account


In its most recent report, consulting firm Dalbar Inc. compared investor returns for the 20 year period ending December 31, 2008 with the returns of the S&P 500 index. The firm found that investors had average annual returns of 1.87% while the S&P 500 averaged a much more impressive 8.35%.

Why the whopping difference?

Investors relied on brokers who chased returns and jumped in and out of the market. Basically, using a broker just ends up costing you money. A study entitled "Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry" by Daniel Bergstresser and Peter Tufano of the Harvard Business School and John Chalmers of the University of Oregon backs up this notion.

The authors compared the returns of mutual funds sold by brokers to ones selected by investors on their own. Here's what they found:
  • Funds selected by investors outperformed funds picked by brokers
  • Funds selected by investors were less expensive than those picked by brokers
  • Brokers did not provide superior asset allocation to their clients
  • Brokers' advice contributed to bad investor behavior, like chasing returns and following fads.
Looking at the data, it's easy to come to one very certain conclusion: You should fire your broker and close your retail account. In fact, I believe your financial well-being may rely on this critical decision.

Shocking tip #2: Sell all of your individual stocks

Many people who buy individual stocks do so because they believe they're going to outperform other stocksand indexes like the S&P 500 and get superior returns. In most cases, this thinking is dead wrong.

When you buy a single stock, you assume both market risk (risk that the markets generally will go down) and "idiosyncratic risk" (risk that something unique to your stock will happen and cause its price to decline).

You can eliminate idiosyncratic risk by diversifying your stock portfolio to include many different stocks. The best way to do so is by owning mutual funds. Studies have shown that an investor in a single S&P 500 stock had the same expected return as an investor who held an S&P 500 index fund. However, the single stock investor was exposed to nearly twice as much risk!

Shocking tip #3: Sell your actively-managed mutual funds

Your broker spews nonsense when he tells you he can pick fund managers or mutual funds that can "beat the markets." I don't care whether the funds he recommends have been awarded a five-star rating from Morningstar. Actively-managed funds are not a good investment idea.

Actively-managed funds are mutual funds run by fund managers who try to beat a benchmark, like the S&P 500. More than 95% of mutual funds are actively managed. Yet, there's overwhelming data that demonstrates that these funds do not perform as well as index funds.

Robert Jeffrey and Robert Arnott published a study titled "Is your Alpha Big Enough to Cover its Taxes?" in which 71 large-cap growth and growth and income active mutual fund managers were compared to the S&P 500 over a period of 10 years from 1982 to 199. Most of the managers invested in styles that closely represented the S&P 500, but not one was exact. Only two of these 71 managers beat the index. That is a mere 3%!

In another study John Bogle determined that only nine out of 355 equity funds beat their benchmark over a period of 30 years. That is just a 1-in-39 chance of choosing the correct mutual fund in advance.

A far more comprehensive study of 1,892 funds that existed in any period between 1961 and 1993 became the dissertation of Mark Carhart while he was earning his Ph.D from the University of Chicago. The study titled "On Persistence in Mutual Fund Performance" found that when adjusted for the common factors in returns, an equal-weighted portfolio of the funds underperformed the proper benchmark by 1.8% per year, before federal and state taxes.

Here's what you can conclude from the studies above:
  • Only a small percentage of actively-managed funds that perform well in one year repeat that performance in the following year.
  • There is no way to determine which actively-managed funds will perform well in any given year or over any period of time.
  • Actively-managed funds are typically higher risk and have lower returns than comparable index funds.
  • The chance of an actively-managed fund beating a comparable index fund over a period of 10 years or longer is about 1 in 39. Your odds are better when you're playing Roulette. At least with that bet you have a 1 in 38 chance.
Shocking tip #4: Stop worrying about the stock market

Relying on the musings of financial pundits is no better than placing your financial future in the hands of a psychic. There's no data that indicates that anyone has the ability to predict the future course of the stock market with any consistency.

Instead of worrying about the day-to-day, month-to-month or year-to-year fluctuations of the markets, focus on finding an asset allocation that works for you. Properly diversifying your portfolio by investing a percentage of your assets in the bond markets and another portion in the stock markets is essential for weathering the market's ups and downs.

To determine the right asset allocation for you, fill out an asset allocation questionnaire. There are plenty of them on the Internet, including one on my web site.

If you have less than five years before you'll need to take out a significant portion of your funds, you should have no exposure to stock market risk. Zero. None. No matter how you think the markets will perform. For investors who can tolerate more risk, having some exposure to the stock markets is the only way to keep pace with inflation.

Shocking tip #5: There are no financial gurus out there.


Generations of investors have devoted a lot of time and money to the search for a guru who can guide them to financial success. But here's the cold harsh reality: They don't exist.

William Bernstein said it best in his latest book, The Investors Manifesto, Preparing for Prosperity, Armageddon, and Everything in Between: "The reason that 'guru' is such a popular word is because 'charlatan' is so hard to spell."

We now know Bernie Madoff was no guru. But many of the most sophisticated investors in the world thought otherwise. Wealthy investors thought hedge fund managers had found the holy grail: huge returns with little risk. Since 2006, 117 major hedge funds at 71 fund families have imploded. Even CNBC's Jim Cramer is wrong about as often as he is right. And "Dr. Doom", Nouriel Roubini, may have been right about the economic meltdown in 2008, but he has been terribly wrong about the market recovery in 2009.

Financial "experts" love to give their opinions about all aspects of investing: When to buy and sell; what stocks are hot; whether gold is a good or bad buy ... the list goes on. But the odds that their predictions are correct are about the same as random choice. Investors who rely on such financial advice risk financial failure.

Shocking Tip #6: Even a second grader can beat the returns of most brokers


Investing isn't rocket science. Allan S. Roth explains in his excellent book, How a Second Grader Beats Wall Street, "owning only three index funds can truly spread your eggs over the entire global basket and make competing with Wall Street such an unfair game -- for them." Further validation can be found in my book, The Smartest Investment Book You'll Ever Read and in John Bogle's book, The Little Book of Common Sense Investing.

Here's what you need to do:

1. First, determine your asset allocation. You can do that in five minutes by taking an asset allocation questionnaire.

2. Buy three low-cost index funds from Vanguard using the following asset allocation:
  • Put 70% of your assets allocated toward stocks into The Total Stock Market Index Fund (VTSMX).
  • Put the remaining 30% of the assets earmarked for stocks in The Total International Stock Index Fund (VGTSX).
  • Then put the entire amount allocated for bonds into the Total Bond Market Index Fund (VBMFX).
3. Rebalance your portfolio once or twice a year to keep your asset allocation intact or to change it if your investment objectives or tolerance for risk have changed.

Here's an alternative to purchasing the three index funds I mention above. You can achieve the same goal by purchasing just two exchange traded funds:
  • Buy iShares MSCI ACWI Index (ACWI). Put 100% of the amount allocated to stocks in this fund. Think of ACWI as a piece of the world's stock market . Its benchmark is the MSCI All Country World Index.
  • Buy iShares Barclays Aggregate Bond Fund (AGG). Put 100% of the amount allocated to bonds in this fund. AGG gives you a broadly diversified portfolio of U.S. investment grade bonds. Its benchmark is the Barclays Capital U.S. Aggregate Index.
Both of these portfolios achieve the same goal: You will own a globally-diversified portfolio of low-cost stocks and bonds in an asset allocation appropriate for your tolerance for risk and investment objectives.

Based on historical data, investors whose portfolios tracked these benchmarks would have outperformed the returns of the average equity investor by more than 400% over the past 20 years.

Shocking Tip #7: Questions to ask an adviser (if you need one)

While some investors can go it alone, others will need financial guidance. Many investors find it difficult to stay the course during tough times or to resist chasing the latest investing fad or high returns. Financial advisers can be helpful to insure that your asset allocation is correct and that you are rebalancing your portfolio periodically. If you have losses (as most investors did in 2008), a competent adviser will suggest tax-loss harvesting, which can save you thousands of dollars.

Here are some questions to ask any adviser who you are considering retaining. A "yes" answer to any question should disqualify him or her:
  1. Do you get any compensation, directly or otherwise, from any source, other than a fully disclosed fee for managing my assets?
  2. Do you believe that anything about my portfolio is more important than my asset allocation?
  3. Can you time the markets?
  4. Can you pick stock "winners."?
  5. Can you pick actively-managed mutual funds that will outperform their benchmarks?
  6. Do you use the Morningstar "star" ratings to help you select mutual funds that will outperform other funds?
  7. Will you use anything other than low-cost index funds, exchange traded funds or passively-managed funds to put together a low-cost, globally-diversified portfolio for me?
A "No" to all seven questions means that you have a keeper!

Dan Solin is a Senior Vice President of Index Funds Advisors, Inc. (ifa.com). He is the author of The Smartest Retirement Book You'll Ever Read (Perigee Books, 2009). His other books include the New York Times bestsellers The Smartest Investment Book You'll Ever ReadandThe Smartest 401(k) Book You'll Ever Read. See SmartestInvestmentBook.com.
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