Guide to Winning Portfolios

As long as we are discussing fund/portfolio management today, have a read what Paul Farrell had to say in his Guide to Winning Portfolios. Its his review of a book he notes is boringly titled Index Funds.  He summarizes many of the ideas in the book:

Step 1: Passive investors win

The game’s fixed. Active investors try to pick the winners from among thousands of stocks and funds. But prices are news-driven. And news is random and unpredictable. Worse yet, "experts" like Wall Street brokers, portfolio managers and traders have an "informational advantage" that makes it impossible for Main Street to beat them. They take advantage of naïve investors blindly throwing money at news tips.

Step 2: Nobel economists win

Hebner has the best survey I’ve seen of research by Nobel Prize-winning economists and other academics. Unlike Wall Street plugging an IPO client or some brokers hustling commissions, they’re objective and unbiased. All this research proves conclusively that indexing and simple asset allocation are the best way to win.

Step 3: Stock pickers lose

Wall Street brags about the stock-picking talents of active managers. Yet research says only 3% of them beat their benchmark, and it’s mostly luck. Stock-picking success is random. And today’s winners are rarely on top tomorrow.

Step 4: Market timers lose

Market timing is a fool’s game. Over a 10-year period, 88% of your returns will come from a brief 40 up days. Nobody can predict which 40 days. An academic study of 15,000 predictions by 237 timers concluded: There’s "no evidence that [market-timing] newsletters can time the market."

Step 5: Picking managers loses

Forget about picking next year’s hot managers. You can’t. The S&P 500 beat 97% of mutual fund managers for a 10-year period ending October 2004. In two 30-year studies, the S&P 500 outperformed 97% and 94% of the managers. And only 12% of the top-100 managers repeated.

Step 6: Style drifters lose

Active managers love playing with your money, churning portfolios. They’re gambling, it’s fun. Their average salary is more than $400,000 annually, even when they lose your money. One study proves that 40% of all funds drift from their stated objective. Reported holdings are months old, so you never really know what’s in any fund, or in your portfolio!

Step 7: Silent partners win

Before you make a dime invisible partners skim money off the top! They’re silent because the SEC doesn’t require funds to disclose details about who’s skimming: expenses, commissions, fees and taxes. In one 15-year study of taxable accounts, actively managed funds returned 50% of the gross, while index funds returned 85% to investors.

Step 8: Risk blindness

The sad truth is, most American investors don’t know that what they’re doing amounts to gambling. They chase short-term returns, follow hot tips, never really understanding the impact that timing and risk-taking have on their after-tax returns.

Step 9: History exposes

Managers come and go. Performance drifts unpredictably over the short term. Indexes are your only reliable source going back 80 years. Raw indexes, not actively managed funds, are the best measure of long-term portfolio risks.

Step 10: Risk capacity

What’s your risk profile? Your risk "capacity" is a combination of five factors: Personal tolerance for risk (anxiety level!), your investment IQ, net worth, income and savings rate, plus time to retirement or any special withdrawal needs. This book has a ton of information on how to determine your risk profile!

Step 11: Risk exposure

Over 90% of a portfolio’s returns are a function of asset allocation and not the specific funds, stocks and bonds. Active management has a negative effect on returns, draining off a third or more. Over a 50-year period, studies show that a diversified index portfolio will outperform the S&P 500.

Step 12: Invest and relax

Hebner says index and relax: The best way to maximize your returns is to avoid active trading, market timing and actively managed funds. Create and build a portfolio of index funds that works for your unique risk profile. Set it and forget it. Buy quality, rebalance periodically. And relax.

A virtual version of the book is online (free) and can be seen here.

UPDATE:  February 13, 2005 5:12am

If you are a regular reader of this blog, you should recognize that I do not agree with everything Paul Farrell suggests. I am obviously an active trader, and I do a lot of market timing.

The purpose of this posting was to highlight the book . . .   

>

Source:

Freakoindex Guide to Winning Portfolios!
Fabulous new indexing tool gets extreme (title) makeover

Paul B. Farrell
MarketWatch,  7:59 PM ET Feb. 6, 2006
http://tinyurl.com/82vjb 

Index Funds: The 12-Step Program for Active Investors (Hardcover)
http://www.amazon.com/exec/obidos/ASIN/0976802309/thebigpictu09-20/

Index Funds: The 12-Step Program for Active Investors (virtual download)
http://www.ifa.com/Book/index.htm

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What's been said:

Discussions found on the web:
  1. royce commented on Feb 12

    It’s interesting to see Farrell push that, because he’s got a book of his own, “The Lazy Investor’s Guide” or some such thing, that lays all this stuff out. So it’s not like you need to pay a fee to IFA to get decent index strategies. In fact, the whole point of index investing is its simplicity.

  2. wcw commented on Feb 12

    While I tend to be very sympathetic to these arguments, I despise argument #4. You can’t set up your objection to a strategy by presuming its practitioners have perfect negative skill.

  3. wcw commented on Feb 12

    Oh, and full disclosure: I believe the result (‘no evidence of timing skill’) is true — it’s the argument using one tail of the distribution that I hate.

  4. duncan Robertson commented on Feb 12

    The best way to maximize your returns is to avoid active trading

    d
    i guess

  5. Lord commented on Feb 12

    Yes, #4 is the most abused statistic around. It is never mentioned that missing the worst days will enhance returns even more than missing the best days, or that the best days are commonly rebounds from oversold conditions so if you miss the decline, missing the advance is hardly threatening. One can significantly reduce risk through timing, which should be it’s main use.

  6. pete Preissle commented on Feb 12

    Farrell has been spouting this nonsense for a long time.

    I’m delighted I didn’t follow his advice on 1/19/01 when I made my first individual stock trade. SPX closed that day at 1342.55.

  7. ~Russian Bear’Z Blog~ commented on Feb 12

    Гид портфельного инвестора

    Интересный взгляд на портфельные инвестиции, впрочем ничего нового, но занимательно
    Очень долго можно дискутировать на тему: как выбрть фонд или акцию для инвестиций, но лучше всего прислушаемся к советам тех, кто уже заработал на этом деньги. Ниже п…

  8. royce commented on Feb 12

    As far as I know, Farrell doesn’t say not to invest in a small cap or real estate index for diversification. If you are going to outperform the index over a 10-20 year period, which is what Farrell talks about, you should start running money. People are always looking for fund managers who can outdo the S&P over the long run. Those guys are very, very rare.

  9. PC commented on Feb 12

    Quotes from your post:

    “Step 1: Passive investors win. Worse yet, “experts” like Wall Street brokers, portfolio managers and traders have an “informational advantage” that makes it impossible for Main Street to beat them.”

    I know quite a few traders who trade purely off a screen at home with no insider information and yet they turn in consistent profits year in and year out.

    “Step 2: Nobel economists win.Unlike Wall Street plugging an IPO client or some brokers hustling commissions, they’re objective and unbiased.”

    Nobel economists were also behind LTCM. Most economists can’t trade their way out of a paper bag in markets. Talk is cheap.

    “Step 4: Market timers lose. Market timing is a fool’s game.”

    Again I know active traders that beat Wall St. pros year in and year out. Saying “Market Timers Lose” is equivalent to the saying “No One Can Play Golf”. Just because some people can’t play golf doesn’t mean everyone can’t play golf.

    “Step 11: Risk exposure. Over 90% of a portfolio’s returns are a function of asset allocation and not the specific funds, stocks and bonds.”

    I remember reading a past annual letter of Berkshire Hathaway in which Buffett said they don’t practice asset allocation and it’s a flawed concept. Their concept is simple – when there is nothing meaningful to do, they stay in cash. And when the odds are in their favor, the load up in a big way. NO ASSET ALLOCATION.

  10. trader75 commented on Feb 13

    Why does no one address the central paradox of indexing — that if everyone went into index funds, indexing would cease to work.

    Someone has to be driving the bus. If nobody adds value to the asset allocation process, as indexers seem to suggest, then how does the market function as an efficient capital allocation vehicle in the first place.

    Apparently no one can claim an informed opinion, and yet the market somehow represents a perfect equilibrium of informed opinion at the same time. Warren Buffett can’t beat the market (he has just been lucky) because there is a group of theoretical investors, all smarter than him, making it impossible to do so. And yet none of these ‘dark matter’ investors manage funds. What a load of sophistry.

    Indexing is a low-wattage, free-rider call option on the permanent bull market. Of course, there’s no such thing as a permanent bull market, and the index lemmings will get what they deserve before all is said and done.

  11. Steveo commented on Feb 13

    80 percent of the volume traded is by institutional investors. Let them drive the bus
    And you dont have to pay for it

  12. Anonymous commented on Feb 13

    The Big Picture: Guide to Winning Portfolios

    Barry Ritholz provides a summary of a new book on which portfolios are winning ones.

  13. B commented on Feb 13

    trader75,
    are you stating that the markets are efficient? i do not believe the markets are at all efficient. And I don’t believe they are efficient in the long term either. I believe they adjust long term when new variables are present or a change in variables exist but I still don’t call that efficient. I know I would find others who would argue with me on both points. But, if that is so, then why did I have a portfolio with a 40% return in 04 and 35% in 05 buying nothing other than index funds? Btw, I can just as well take advantage of down markets so I am an indexer and I don’t think I will ever get my due as you say. In fact, my edge is speed. Mutual funds and large leverage funds that “make bets” can never move as fast as I can. That is why they get slaughtered when the trend moves against them. Their capital is usually at work with a “bet” and to unwind that bet cannot be done quickly as a fast moving individual investor can.

    I’ve argued this on this board. I don’t want to get into a long bunch of philosophical posts but I can assure you that quants can beat the markets consistently. Jim Simons has done in for tweny years with a legion of mathematicians. David Dremen, who I respect as an investor more than Buffett, just was quoted as saying market efficiency is hogwash. Goldman Sachs’ trading group would tell you the markets were not efficient. Ditto with oil. If the world knew we were running out of oil and China was growing faster ten years ago than today, why was oil at basically $10 a few years ago? Did someone just wake up and decide we were running out of oil. Btw, I can assure everyone we are not running out of oil and that is not the reason oil is going up. Why did the Nikkei go up 40+% in a few months? The the outlook on Japan’s economy change by 40% in a few months?

    The FTSE is nothing more than one big bunch of index funds. No one buys individual stocks over there. Overstatement but I’m making a point. Yet the FTSE has done quite well comparative to the S&P. Index may be low wattage but 90%+ of funds do not beat their targeted objective index. Small cap, mid cap, large cap, small cap value, etc. So what does that make them? IMO backed up with models that work and do beat the market with indices.

  14. Chad K commented on Feb 14

    I may not be able to predict the 40 days in 10 years when big gains are made… but I can seem them very clearly when they happen… which makes it easier to dump the stock when it’s P/E just went from something reasonable to something outrageous.

    I’m not about being a trader… one to three trades a month is the most I’ll usually do… I prefer to make intelligent long-term decisions… but when a stock in my portfolio goes up 15% in a day… and my personal expectations for it’s 1-yr growth were about 15%… I’ve found much advantage in dropping it as near to the peak as possible. Several months later when they come back down to earth… I’ll check it out again, in the same manner I did before, and if it fits into my set of goals, I’ll buy it back.

    I’m not sure this can be called market timing, since that’s not my goal… but it’s certainly been a good thing, being able to see the 40 of 4000.

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