Passive vs. Active

The vast majority of investors will do better owning a portfolio of passive investment instruments rather than actively managed funds.  Actively managed funds rely on market timing and stock selection – research shows that these methods simply do not add value over time.  You can visit Standard & Poor’s website and download the Standard and Poor’s indices versus active funds scorecard (SPIVA report).  In a recent report, this analysis showed that over a trailing 5 year period, over 70% of large cap funds had failed to beat their respective benchmarks.  In looking at other asset classes, including mid-caps, small-caps, international, emerging market, and all types of bond funds, the pattern is constant – managed funds fail to beat simple index instruments.

Why is this the case?  One reasons is the excess fees incurred by owning retail mutual funds.  When you look at a mutual fund’s expense ratio, you are only seeing a part of the story.

Mutual Fund Fees

There are four components to mutual fund fees.

• Management fees – the fees charged by investment managers
• Distribution fees – the fees paid to the salespeople
• Transaction costs – commissions and market slippage
• Taxes – capital gains distributed in non-qualified accounts

Many funds end up costing investors well over 2% annually after factoring in all these costs.

Diversification

Being a successful long term investor requires diversification.  Many investors fail to understand the risks involved with being under-diversified.  Avoidable risks include holding too few securities, concentrating too much of your portfolio in one sector or country, trying to time when to get in or out of the market.  All these issues can be solved by proper diversification.  Capitalism provides a finite return on invested capital over the long term.  The only way to be assured of receiving that return to invest in a widely diversified manner.

In constructing a diversified portfolio, an investor should invest in large stocks, small stocks, international stocks, emerging market stocks, real estate, and bonds.  By combining these asset classes in different proportions, a proper portfolio can be built for an individual investor based on the investor’s ability to assume risk.

Risk vs Return

Most investors view risk as the negative part of investing.  Webster’s Dictionary defines risk as “exposure to the chance of injury or loss”.  But this is only part of the story.  A better definition of risk is “the uncertainty of expected returns”.  An investment in the most conservative investment possible yields the “risk-free return”.  Traditionally, this has been US Treasury securities.  Currently this investment yields very close to zero.  For an investor to yield a better return than the risk free rate, the investor must take risk.  What does this mean?  Risk is “uncertainly of expected returns”.  So for a given time period, for an investor to achieve a better return than the risk free rate, the investor must accept a certain degree of uncertainty, or risk.  This is the essence of investing.  The more uncertainty an investor is willing to accept, the higher the expected return over long time periods.  This can be viewed graphically in the chart below.  The fluctuation of returns is measured using a statistical term called standard deviation.  Put simply, the higher the standard deviation for an investment, the more the returns fluctuate from month to month and year to year.  The essence of investing is that to achieve a higher returns, more risk (or standard deviation) must be accepted.