Tuesday, February 11

6 reasons your investments stink

6 reasons your investments stink
| By Brett Arends, MarketWatch

Have you ever looked under the hood of your mutual fund? Many of them suffer from a common set of problems.

Wouldn't it be great if there were an investment portfolio you could just forget about? Wouldn't it be great if you could free yourself from the madness of the market and go fishing?

Some people -- including, naturally enough, many MarketWatch readers -- are fond of playing the great game of the financial markets. But others just want to leave their money to work for them quietly.

I have a personal interest in this. I have come to accept that I cannot manage my own portfolio and write actively about the markets. There are strict rules keeping one's personal holdings a million miles from anything one writes about (and quite rightly so). This means I have to give my best tips to my readers, and then I can't buy them myself.

I've decided I just don't want the stress of managing a portfolio, either. Yes, I think a well-run portfolio can beat the market over time. But to do that you need a free hand. And you need to manage it actively: You need to be able to pounce on stocks, sectors, and even markets, when their price falls too far, and sell those that have risen too high.

So I have come to decide I just want to join Main Street and put my money into those fire-and-forget portfolios.

But then I started looking at them, and I came to a harsh conclusion: All the options on offer are fundamentally flawed. They're rubbish.

That includes "target date" funds. It includes managed portfolios by most financial planners. It includes those cookie-cutter "smartest portfolios" you sometimes read about. It even includes index funds.

I'm not even talking about the failings of "active management" -- the fact that most active, stock-picking mutual fund managers end up underperforming their own benchmarks. I'm talking about the new low-cost stuff as well.

Why are they inadequate?

Check out any target date fund and you'll find that 80 percent of the stocks they own are U.S. stocks. The U.S. accounts for about one-fifth of the world's total economy. Why should it account for most of my stock portfolio?

Even the people running these funds know this is silly. At a dinner a couple of years ago I sat next to the chief of the target date fund operation at one of the biggest fund companies in America. I asked him why nearly all their equity exposure was in the U.S. He sighed. "Because that's what the customers want," he replied.

Have you ever looked under the hood of these "index" funds and exchange-traded funds? The marketing departments of the fund companies claim that they are giving you the maximum diversification, what in Wall Street jargon is sometimes called "the market portfolio."

But it's hooey. Most of these funds are massively overweighted toward a handful of individual stocks, simply because those are already the most popular and "valuable." A fund tracking the Standard & Poor's 500 Index ($INX) has a fifth of its money in just 10 stocks. It puts 100 times as much of your money in Apple (AAPL) as it does in, say, Owens-Illinois (OI). That is not diversification. Indeed these funds automatically invest more in the more popular and fashionable stocks.

There is a great deal of research which says that an "equal weighted" portfolio -- for example, one that just holds the same amount in each of the S&P 500 stocks -- will beat these skewed funds over time.

I am tired of people telling me to put all my faith in that standard panacea, a "balanced" portfolio of stocks and bonds. Bah. Since 1982 stocks and bonds have both gone up together most of the time. And guess what? If they can both go up together, they can both go down together. That's what happened in the 1940s and the 1970s. People who entrusted their money to this simplistic "balanced portfolio" malarkey got royally hosed. Thanks, but no thanks.

They own too many U.S. Treasurys, and too many short-term bonds paying bupkis -- deadweight in the portfolio. They own too few zero-coupon bonds (the best insurance against a stock market crash), too few foreign bonds and too few from countries -- such as Norway, Australia and New Zealand, and certain emerging markets -- with the best credit.

Do I need some gold or gold-mining stocks? Timber? Commodity futures? Natural-resources stocks? Inflation-protected securities? If I need commodities, how do I protect myself against getting absolutely hosed on the fees or trading costs? The one thing I know: By the time the money managers work it out, it will be too late.

For example, there is a lot of research showing that over time cheaper "value" stocks, and those of "high-quality" companies, have produced better returns, with lower risk, than other stocks. It is highly likely this is a persistent feature of the market, based on the flaws in market psychology. Give me a simple portfolio that exploits that.

I'm on a quest to construct the perfect "all-weather" portfolio. Stay tuned.

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