10 Investing Facts You Probably Don't Know -- but Should

Individual investor
Individual investor

The securities industry spends hundreds of millions of dollars a year in advertising, but that doesn't mean the general public is getting the straight scoop. Nor does the blanket coverage from the financial media ensure that the public is shielded from misinformation. So, as you contemplate investing for the New Year, here are 10 facts you probably don't know (but should):

This wasn't the "lost decade": All the talk about the "lost decade" is complete nonsense. Investors who bought and held a globally diversified portfolio of low-cost stock and bond index funds did just fine. Dividing that portfolio into 60% stocks and 40% bonds, while not suitable for everyone, is an average asset allocation and is routinely used by defined-benefit retirement plans. The annualized return for that asset allocation for the past decade was approximately 6%. Investors in a portfolio of 100% stocks, invested in the same globally diversified manner, had an annualized return of almost 8%. But, yes, it was a "lost decade" for those who invested all of their assets just in the S&P 500. I don't know why anyone would do that. I also don't understand why any "expert" would use that index as a benchmark for the entire market. It isn't.

2."Great" companies can be lousy investments: Consider Lehman Brothers, WorldCom, General Motors, Conseco and Chrysler. Companies that are "great" one day can tank the next. There's no way to tell who's next.

3. The S&P 500 Index is very unstable: While most investors understand that companies enter and exit the S&P 500 index periodically, few understand just how unstable it is. In the 41 years from 1957 to 1998, only 74 of the original 500 companies were still in the index.

4. Most investment clubs underperform the market: An extensive study of the performance of 166 investment clubs showed 60% did worse than the market. There are many reasons for joining an investment club, but superior investment performance shouldn't be one of them.

5. Mutual fund out performance can be explained by luck, not skill:
This is the big one. When mutual funds tout their great performance over the past five years, they want you to believe their fund managers have superior stock-picking skills. Not true. A recent study found no evidence of skill in the performance records of over 2,100 funds. The study's ramifications are profound. If outperformance is based on luck, there'is no way to predict the next lucky fund. Investors should avoid all actively managed mutual funds and invest in a globally diversified portfolio of low-cost stock and bond index funds instead.

Most investors should not hold individual bonds: Most investors would be far better off selling their individual bonds and buying a low-cost, short- or intermediate-term bond index fund. They would get greater diversification, superior management of their bond portfolio, more liquidity and lower cost. A study by Vanguard summarizes these advantages.

7. Most investors should not hold individual stocks:
An individual stock has the same expected return as the index to which it belongs, but it can have up to twice the risk. That's because holding an individual stock entails risks that are unique to that stock, like corporate dishonesty or the death of a key executive. You can get the same expected return, with less risk, by investing in the index. Same return, less risk. You would think it would be a "no-brainer." Yet investors, egged on by their brokers and looking for the next monster stock, continue to gamble with their money by investing in individual stocks.

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8. Warren Buffett does not "beat the market": I'm a huge fan of Buffett. Most investors believe his company, Berkshire Hathaway (BRK.A), has consistently beat the market. Not true. The index with approximately the same standard deviation (a measure of risk) as Berkshire Hathaway is the Emerging Markets Value Index. For the 10 and 20 years ending Dec. 31, 2005, Berkshire Hathaway stock underperformed that index. You can see the analysis here.

9. Warren Buffett advises investors to invest in index funds: Over the years, Buffett has repeatedly recommended that investors stick to low-cost index mutual funds. He even prefers them to ETFs, as he explained in an interview on CNBC in May, 2007.

10. Chasing big returns causes the brain to react just like snorting coke: Both activities are addictive. This explains why investors act so irrationally and fall easy prey to brokers and advisers who claim they can "beat the markets." The brokers are drug dealers, and the investors are addicts. You can compare the brain images of investors looking for a big score and drug addicts doing the same thing, here.

The next time you're confronted with an investment decision, take a look at these 10 facts. Then fundamentally change the way you invest.