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Getting to the truth of Stock Mutual Funds November 2, 2007

Posted by shaferfinancial in Uncategorized.
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The industry that I call “Wall Street” makes it money by convincing people to buy and sell stocks as often as possible. Of course, part of the problem of that business is how to get people to overcome their natural aversion to losing money. How has WS solved the human behavior problem of risk aversion?

The great depression was a huge public relations problem for WS until WWII. After the war academic folks gave WS some much needed ammunition. That is the discovery of diversification and the creation of mutual funds significantly reduced risk. No longer did the poor performance of stock pickers mean total loss.

Probably the biggest boom to stock pickers (money managers) was the invention of mutual funds because now their mistakes could be glossed over as a bad year and they would live to play the game in the next year. Now some of you know, but it is worth repeating that stock pickers (whether they call themselves that or not is irrelevant) universally underperform the market. In study after study this is constant. You would be hard pressed to name a handful of stock pickers who beat the market over a 15-year period out of the universe of hundreds of thousands of stock pickers.

Study after study demonstrates that the buy and hold strategy is the only chance one has in coming close to matching the market returns. This goes for stock pickers as well as individuals. Dalbar, Inc. has performed probably the definitive study on investor behavior when it comes to stock mutual funds. For the 20-year period 1985-2004 it found that individual investors in mutual funds had a 3.5% rate of return. During this same time period the market returned 12.9%.

What does this mean? It means that the actual behavior of individuals hasn’t changed much in the last century. Despite much propaganda encouraging folks to buy and hold mutual funds through market upturns and downturns, individuals sell when the market or their funds do poorly.

The question you need to ask yourself about owning stocks is very simple. Can you withstand seeing the value of your portfolio go negative 20%, 30% or even more? Because it will. And if you or your financial advisor is tempted to sell those poorly performing funds to buy something else or to sit on the sidelines for a while you will end up with a poorly performing portfolio. The evidence is overwhelming on this fact.

Interestingly, another side fact from this study is that folks with financial advisors don’t do any better than folks who make the decisions themselves without advice.

If your advisor is selling you on annual reviews to sell loser funds, asset allocation percentages that require annual changes or anything that is similar remember the research is consistent in that the more active you manage your money the poorer you do.

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