Investment Approaches

How Do You Invest for Success?

How Do You Invest for Success?

In this section we explore possible investment approaches you might consider and show you the hard facts on their success (or more commonly, their failures!):

You may not want to read all of what follows. So for the impatient or disinterested who just want to know the bottom line, I recommend you don’t do any of these approaches, except you might want to hire a good financial advisor. But understanding why you don’t want to do these will help you avoid the inevitable temptation to do them. Read on if you want to understand. Controlling your actual investing behavior is equally important to knowing the right investment techniques.

“Individuals’ gains are not primarily influenced by intelligence or special knowledge, but by temperament.”
– Legendary Investor Ben Graham

Pick Stocks

Let’s look at how the pros do it. By pros, I mean mutual fund managers, brokerage houses, and other professional stock pickers. Many of them are paid more than seven figure incomes. They utilize hordes of smart people with MBAs, Masters of Finance and Certified Financial Analyst credentials to:

  • Analyze publicly traded company financials in depth
  • Call and meet with the companies
  • Talk to experts and “insiders” in the companies’ industries
  • Review earnings forecasts and industry outlooks
  • Research expert opinions, news and special research reports
  • Utilize technical analysis to choose the best entry and exit point for buying/selling
  • Buy in volume using their own or closely related brokerage firms to gain favorable trading advantages
  • Spend millions of dollars on research
  • Do all of the above to determine the best time to buy and sell

Do you have the skill, access to resources, expertise and time to do this?

Given all that, you would think the really smart money, or at least a subset of them, would consistently beat the market. Let’s take a look at brokerage house picks and mutual fund managers’ records.

“Put another way, the simple fact that there are so many talented analysts examining stocks guarantees that none of them will have any kind of advantage, since the stock price will nearly instantaneously reflect their collective judgment. In fact, it may be worse than that: there is good data to suggest that the collective judgment of experts in many fields is actually more accurate than their separate individual judgments.”
– William Bernstein, The Four Pillars of Investing

Performance of Leading Brokerage House Top Picks

How many people take the advice of their broker about a few stocks they recommend? Unfortunately, I believe it is quite a few. Many brokers who deal with investors are salespeople, not professional investors with training in investment analysis. They are parroting recommendations from their own experts, which as you will see below, mostly aren’t very good.

A Barron’s-Zach’s stock-picking contest compared brokers’ top picks versus each other and the S&P 500 index. The results show a lack of consistently superior returns over all time periods for the top performing brokerage firms. Note that returns overstate actual returns to investors since they don’t take into account transaction costs, timing of buy/sell and taxes.

Source: The Little Brokerage That Could, Barrons, Jan 28, 2013

Source: The Little Brokerage That Could, Barron’s, Jan 28, 2013

A few takeaways:

  • The top performing broker in 2012, Goldman Sachs, earned less than the S&P 500 Index over the three year period (29.12% vs. 36.30%) and five year period (4.10% vs. 8.59%).
  • The top performer for the three year period, Wedbush Securities, beat the S&P 500 Index over the five year period also (13.27% vs 8.59%). However, this run of superior performance didn’t persist (see below).
  • Only one firm, McAdams Wright, beat the S&P 500 Index over each time period.
  • Three of the eight firms (37.5%) beat the S&P 500 Index over the five year period.

My original research on this was in 2014. In 2019, I looked for the most recent data I could find. The latest came from Barron’s in 2015 (see below). It’s interesting that there appear to be no additional reports published by Barron’s. Could it be that the brokerage houses don’t care to lay bare their actual performance? Or could it be that Barron’s, a publication chock full of ideas for active investors, doesn’t want to dissuade investors from reading their great insights? In case you think I’m not a fan of Barron’s, I am an avid subscriber and value their insights, even though I am a passive investor.

A few takeaways comparing the 2012 and 2015 data:

  • Wedbush, the top three year performer at year end 2012, lost 1.36% in the 18 months ending June, 2015, while the S&P 500 Index returned 15.08%.
  • McAdams Wright, the top five year performer at year end 2012, didn’t show up at all in the 2015 study. Was this because they stopped participating? Or maybe they declined to report their data? If it was excellent, why wouldn’t they want to publish it?
  • Only one firm, Morgan Stanley Wealth Management, outperformed the S&P 500 Index in the 18 month period ending June, 2015. They weren’t listed in the previous study, so hard to know their performance over a longer period.
  • The average brokerage house performance over the 18 months ending June, 2015 was 11.63% versus 15.08% for the S&P 500 Index.

At best, the performance of brokerage houses is rarely better than the market and is inconsistent over time. It is difficult, if not impossible, to pick the best brokerage house that will persistently outperform. The data are consistent with the reversion to the mean phenomenon (see below) exhibited by mutual fund managers.

At worst, investing in the picks of brokerage firms can lead to inferior pretax returns, made even worse by high trading costs, high taxes, and the effort and time required to follow and implement their advice.

Finally, even if you were to somehow choose a firm that is exceptional and consistent over time (highly doubtful), you won’t get the benefit of their stock picking by going with a just a few of their picks. You will need to go with ALL their picks so that you have a portfolio that mirrors their picks, which may easily number 20, 30, or 40 stocks. All stock pickers have losers and perhaps some home runs. You will also need to track their buy and sell decisions carefully to earn the returns of the winning firms in the table.

OK, so picking and following a good broker probably won’t work, but what about mutual fund managers?

Performance of Mutual Fund Managers

“Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice. That is, mutual funds charge their investors big fees and usually fail to deliver returns that beat the market.”
– David Swenson, Chief Investment Officer, Yale Endowment Fund

Source: Morningstar Magazine, Spring 2019

The chart at right shows the percentage of actively managed equity funds that earned lower returns than their respective benchmarks for each of the major equity style boxes.

The market index generated higher returns 57-94% of the time across all categories over the recent five year period.

As you might expect, the data are better for active managers over shorter time periods. During 2018, the best performing category was Large Core funds, when 72.8% of active managers outperformed their benchmark. However, overall only three other categories outperformed their benchmarks during 2018. These results are consistent with our overall findings that active management does not persistently outperform the indexes over longer time periods. We illustrated that with the brokerage houses above and will cover below with respect to mutual fund managers.

The table below shows the percentage of actively managed funds that earned returns less than their benchmark index for other categories of equities and fixed income in the period ending in 2011.

“The true numbers are actually worse because the returns evaluated by S&P are not adjusted for loads.” – Index Advisors Source: Index Funds Advisors quoting Standard and Poors

“The true numbers are actually worse because the returns evaluated by S&P are not adjusted for loads.” – Index Advisors
Source: Index Fund Advisors quoting Standard and Poors

For the 5, 10 and 15 year periods ending in 2000, only 16%, 16% and 17% respectively of actively managed funds outperformed the Wilshire 5000 index. From 1963-1998, there were just 14 years (39% of the time) when more than 50% of active managers beat the S&P 500 index (a large-cap index). Of those 14 years, in 13 of them, small-cap stocks beat large-cap stocks. Since the average fund holds small caps and large caps it explains much of the outperformance of active managers.*

*Source: Swedroe, “Investment Mistakes Even Smart Investors Make,” 2012, p. 82.

Costs Matter

Why do active managers underperform? The main reason is cost. According to a study published in the Journal of Finance* the returns of active equity fund managers were reduced by a total of 2.3% per year on average due to three main cost components.

Sources: Swedroe, “Investment Mistakes Even Smart Investors Make,” 2012 Russ Wermers, Journal of Finance, Volume 55, August 2000

Sources: Swedroe, “Investment Mistakes Even Smart Investors Make,” 2012
Russ Wermers, Journal of Finance, Volume 55, August 2000

The chart below shows how costs affect long-term portfolio growth. It depicts the impact of expenses over a 30-year horizon in which a hypothetical portfolio with a starting value of $100,000 grows an average of 6% annually. In the low-cost scenario, the investor pays 0.25% of assets every year, whereas in the high-cost scenario, the investor pays 0.90%, or the approximate asset-weighted average expense ratio for U.S. stock funds as of December 31, 2012. The potential impact on the portfolio over three decades is striking—a difference of almost $100,000 between the low-cost and high-cost scenarios.

For mutual funds, higher costs can significantly depress a fund’s growth over long periods. Costs create an inevitable gap between what the markets return and what investors actually earn—but keeping expenses down can help to narrow that gap. Lower-cost mutual funds have tended to perform better than higher-cost funds over time. Indexed investments can be a useful tool for cost control.

Lower Cost Funds Perform Better

The illustration below compares the ten-year records of the median funds in two groups: the 25% of funds that had the lowest expense ratios as of year-end 2012 and the 25% that had the highest, based on Morningstar data. In every category, the low-cost fund outperformed the high-cost fund.*

“The shortest route to top quartile performance is to be in the bottom quartile of expenses.”
– John Bogle, Founder, The Vanguard Group

Pick the Best Performing Mutual Funds

Past performance does not predict future performance. The data from Bogle and Morningstar clearly show it is very difficult to pick the winning mutual funds that will sustain superior or even average performance in the future. The chart below shows the concept of “reversion to the mean.” For example, on the left we see that the top performing quartile of funds in the 1970’s averaged returns of only 0.7% per year above the average fund during the 1980’s. Curiously, at the right hand side of the chart, we see that the lowest performing quartile of funds of the 1970’s (4.1%/yr less than average), performed equal to the average fund during the 1980’s.

Source: John C. Bogle, “Common Sense on Mutual Funds,” 1999, p. 229

Source: John C. Bogle, “Common Sense on Mutual Funds,” 1999, p. 229

“I own last year’s top-performing funds. Unfortunately, I bought them this year.”
– Anonymous Investor

Morningstar, a leader in mutual-fund research and analysis, assigns a “Star Rating” of 1-5 (5=best) to funds based on past performance. In 2009, the funds that were rated 5 stars in 2004 were now rated 3.2, on average. Those funds outperformed 59% of actively managed funds during that period.

Given that the average fund underperforms their benchmark on average by 1.5% per year (Bogle’s research* indicates 0.4%-5.0% depending on the time period), this means the 5-star funds likely underperformed their indexes. The 2007 group of 5-star funds were underperforming the 1-star group. The 2005 and 2006 5-star rated funds had ratings of 3.1 and 2.9 in 2009.

From the Morningstar data above and the chart from Vanguard above, it is clear that it is more important to look at mutual fund cost than past performance in choosing a winner.

“The best way to own common stocks is through an index fund.”
– Warren Buffet, Chairman, Berkshire Hathaway

Follow Smart TV Analysts

Do you watch CNBC, Fox or other financial programming? While I have to admit I sometimes enjoy them, I never use them for investment advice. My strong belief is that they should be viewed for entertainment only, not investment advice.

Mad Money

Here is an example. Mark Hulbert compared the overall performance of Jim Cramer’s (CNBC Host of “Mad Money”) Action Alerts with the Wilshire 5000 index for the calendar years 2009, 2010 and 2011. You can find the chart here.

Hulbert found that over the three-year period, Cramer’s recommendations would have delivered an investment performance of roughly 9.9% a year – and this did not account for trading costs or tax obligations that accumulate when you’re buying and selling 10 or 11 times a day. During the same time period, the Wilshire 5000 index delivered an average annual return of 14.9%, according to Advisor Perspectives.

Check out this article too: The Dangers of Listening to Financial Pundits

Buy and hold a basket of stocks

Another approach is to simply buy a diversified basket of solid stocks and hold on to them. Don’t try to pick the best stocks or move in and out of them. This seems like a reasonable idea. It has the potential advantage of low turnover and higher tax efficiency vs. buying a mutual fund.

However the advent of tax-efficient ETFs and tax-managed mutual funds have mitigated this advantage, with the convenience of a single trade to alter a position of diversified equities. More importantly, buying a basket may be less effective than an ETF due to the risk of buying the wrong basket of stocks. By concentrating your portfolio in as “few” as 60 stocks (which many would consider significant portfolio diversification), you run the risk of significantly lower returns (and higher risk) than the market. Lower concentrations (fewer stocks) result in even higher chance of underperformance.

Source: The Four Pillars of Investing, Richard Bernstein, 2002, p101

Source: The Four Pillars of Investing, Richard Bernstein, 2002, p101

The chart above illustrates this. The chart shows the returns of 1,000 randomly generated stock portfolios vs. the market return (S&P 500). Note that in the 60 stock portfolio, one out of 20 (5%) of the randomly generated portfolios outperform the market by a margin of 1.77 to 1. This equates to an annual return advantage of 2%/yr., enough to put the random portfolio into an investing “Hall of Fame.” However, if you were unlucky enough to select any of the portfolios in the bottom 25%, after 30 years you only received 70 cents on the dollar relative to the market return.

A recent article by financial advisor Larry Swedroe, “Individual Stock Picking Increases Risk,” states: “Recent studies show that that the returns to equity investors have historically come from a relatively small number of stocks.”

Pick the best asset classes

Given the data about the difficulty of picking superior stocks or mutual funds, perhaps you can pick the best asset classes? You can do your own research and/or consult expert sources and decide that interest rates are sure to go up, so avoid bonds. Foreign stocks and emerging market stocks look cheap, so buy them. Value stocks are out of favor, so buy them. Whatever you think are the best bets, align your portfolio with the most attractive asset classes by buying index funds and ETFs of those asset classes.

Let’s see how asset class returns have varied over time:

Here are some key takeaways:

  • The best performing asset class varies from year to year and over longer periods, e.g. 3-10 years.
  • For example, from January 2000 through December 2009 the S&P 500 lost 24% of its value and delivered a total return (including dividends) of about minus 9 percent (data from Wells Fargo).
  • From 2001-2012, gold went up 12 straight years, then dropped by 28% in 2013 and gained about 2% in 2014.

No one can reliably and consistently predict asset-class returns, or even the relative returns of asset classes year to year.

Looking at the recent period of 2015-2019 illustrated below, you see similar variation of winners from year to year.

However, as we saw earlier, the relative returns of the major asset classes have been fairly stable over the very long run (30+ years). As we discuss in Designing Your Portfolio, by diversifying and holding a mix of asset classes for the long run, you will do well.

Time the stock market

Can you time the market? You can read my most recent article on this topic at Advisor Perspectives.

Also, take a look at the chart below.

*Sources: Money Magazine, August, 2010, p. 118. Gibson, “Asset Allocation,” 2008, p. 78.

*Sources: Money Magazine, August, 2010, p. 118. Gibson, “Asset Allocation,” 2008, p. 78.

Much of the problem with market timing is that a disproportionate percentage of the total gain from a bull market tends to occur very rapidly at the beginning of a market recovery. If a market timer is on the sidelines, they will miss much of the action.”
– Roger Gibson

According to research cited in a 2012 Barron’s article*, 85% of sell or exchange decisions that investors make are wrong. In the 20 years ended 2008, a period that included the best decade of performance ever for stocks, the average stock fund investor averaged only a 1.9% annual return (due to poor buy and sell decisions) even though the average stock mutual fund returned 8.4% annually over the same period. With compounding, the difference was about nine-fold: 402% vs. 46% over 20 years. So an initial investment of $10,000 for the average investor would have grown to $14,600 making active trading decisions vs. $40,200 for the investor that bought an average fund and did nothing over that time.

The evidence from other sources also shows that average investors are bad at market timing. As a result, they underperform with the funds they hold. The Morningstar study depicted below shows the difference in returns for all funds in a recent 10-year period was 1.5%/yr. $100,000 invested in all funds for those years equates to terminal value of $137,379 with buy and hold, vs. $118,279 with the active approach.

Sources: Morningstar Swedroe, “Investment Mistakes Even Smart Investors Make,” 2012, p9

Sources: Morningstar and Swedroe, “Investment Mistakes Even Smart Investors Make,” 2012, p9

Roger Gibson, in his book Asset Allocation, cited research indicating that for market timing to pay, investors must predict the market correctly at least:

  • 80% of the time for bull markets and 50% for bear markets, or
  • 70% of the time for bull markets and 80% for bear markets, or
  • 60% for bull markets and 90% for bear markets

He also cites another book, “Investment Policy,” where the author cited a study of 100 pension funds: “…their experience with market timing found that while all the funds had engaged in at least some market timing, not one of the funds had improved its rate of return… In fact 89 of the 100 lost as a result of timing and their losses averaged a daunting 4.5% over the five-year period.”

Trust a good financial advisor to guide you

There are many good financial advisors that can assist you, if you know how to pick the right one. I believe many investors can do very well setting up and managing their investments without an advisor. This site is all about helping you do it yourself and giving you the knowledge and tools to do so.

If I already convinced you to do it yourself, you can go right to Asset Allocation. However, there are other things advisors do besides helping you set up and manage your investments. And not everyone has the motivation, time and ability to go it alone. So if you think you might want to use an advisor, read on for my suggestions.

Why Use an Investment Advisor?

Why might you want to use an advisor? Here are some of the situations that might warrant doing so:

  • Making sure your money will meet your goals, including retirement
  • You simply aren’t comfortable with your investing skills and/or investment performance
  • Handling the inheritance of a large sum of money
  • Preparing for a marriage or divorce
  • Financial planning for birth or adoption of a child
  • Facing a financial crisis such as serious illness, layoff or natural disaster
  • Caring for aging parents or disabled child
  • Coping financially with the death of a spouse or family member
  • Funding education
  • Buying, selling or passing on a family business

Advisor Fees

Advisors most typically charge based on a percentage of client assets. A typical range is 0.25 – 1.00%. That may not sound like much, but in a world where many experts are predicting future stock market returns of only 4-6% per year, higher priced advisors can easily take away 20-25% of your pre-tax investment earnings.

If you look at it on an after-tax basis, it can be much more. For example, if you earn 5%/yr. and you are in a 25% tax bracket, your after-tax returns are 3.75%. Take out 1% for your advisor and your net after-tax returns are 3.0%, but only if you are able to fully deduct the advisor’s fee as an investment expense.  If you are in the alternative-minimum-tax (AMT) bracket or have no other miscellaneous deductions (which are deductible only above a threshold of 2% of AGI), the advisor fee deduction is useless, and the advisor’s after-tax bite is effectively even higher — your after-advisor, after-tax return is now only 2.75% and the advisor has taken 27% of your returns, and even more if you’re in a higher combined federal and state tax bracket.

What to Look for in an Advisor

If you want an advisor, I recommend you look for someone that meets all of the following:

  • Charges on a “fee only” basis (not commissions for products sold) with a reasonable fee level, e.g. 0.25 -0.50% of assets, or a flat fee per year of $2,500-$10,000. Amounts may vary based on your portfolio size and scope of services that the advisor provides.
  • Believes in a passive strategy with asset allocation.
  • Has a strong client base (assets under management of at least $100M) with solid references.
  • Is a registered investment advisor with the right credentials, e.g. CFP, CFA or ChFC.
  • Passes a background check at
  • Can sell you any investments and not just those from their own firm. Beware advisors from large financial institutions who push their own firm’s products, even if they don’t earn a commission.
  • Emphasizes securities with low costs, e.g. publicly traded low expense ratio ETFs and/or mutual funds from Vanguard or Dimensional Fund Advisors (DFA).
  • Has no conflicts of interest or differences in philosophy with you (ask them what potential conflicts might exist).

You can look at the Bogleheads site or many others for potential advisors. This is by no means meant to be a short list or recommended list for you but can serve as a starting point. Another source is Barron’s Magazine annual list of top advisors. Recommendations from a trusted friend can also help, but I highly recommend they still meet the criteria listed above.

Be Wary!

A paper released by the National Bureau of Economic Research cited work by a Harvard economics professor from 2008. They sent fictitious shoppers on 300 visits to banks and retail investment firms. The shoppers had pretend portfolios of $50-100,000 and different issues: one group chased performance, another owned too much company stock, another had a well balanced mix of low cost index funds, and another was in all cash. The findings indicated that advice givers were far more supportive of chasing performance than they were of index funds and were likely to recommend a switch to expensive, actively managed ones. And when they discussed fees, they tended to downplay them, without actually lying. (source: Money Magazine, June 2012, p9)

So be wary of the following:

  • Any advisor from a brokerage house, bank, insurance company or financial services firm. Better to choose a smaller boutique that specializes in unbiased financial advice with no financial products to sell. My recommendation is NOT to use a major brokerage firm at all.
  • Commission-based brokers.
  • Insurance agents who say they are financial advisors or planners.
  • Advisors who don’t meet the criteria laid out above.

“Definition of a stockbroker: Someone whose objective is to transfer assets from your account to their account.”
– Anonymous

Does your broker have your best interests at heart? Read this.

Here are some good resources for you to learn about and find a good advisor:

Go to the Next Article: Active vs. Passive Management