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If you think you can do better than the market average, you likely are wrong

June 25, 2012

Up and down the market goes. Try to keep your balance so you don’t get catapulted off.

In the past couple of weeks I have shared three questions everyone should ask themselves about their individual investment strategies. Now, we will look at the last two questions Goldie and Murray address in the book “The Investment Answer.”

It is time for me to wrap up this trilogy column as the book currently is overdue at the Sterling Public Library, and after this riveting three-week series, I imagine it is in high demand. My apologies, SPL. I’ll have it back in a couple of hours.

The first three decisions looked at hiring a financial advisor, your risk tolerance and diversification. The last two decisions revolve around active versus passive investing and rebalancing your portfolio.

In general, we all think we’re pretty good. If I asked if you were an above average driver, I imagine most of you would say “Yes.” The only problem is that half of you are average or below average (for those that struggle with math, I’ll give you a little time to contemplate that).

This self confidence can help us believe that if we watch CNBC for 30 minutes a day, we can do well in actively picking stocks, instead of just finding index funds and letting our money sit for long periods of times.

The problem is, almost all of us can’t do better than the market average. There are thousands of mutual funds where an active manager or group of managers study stocks all day and try to pick the best or time the market. When the expenses are added in for purchasing these funds, 70-80% of them do not beat the market average during a five-year period. If the people who study stocks all day generally can’t beat the market, you probably can’t, either.

Even though we can’t pick the best stocks, it is probably easier to time when the market is going to go up or go down, right? Wrong. This idea of market timing is why the S&P 500 has average 9.87% a year growth while most individual investors continue to buy high and sell low to average around 5% a year growth.

It is too difficult for individuals to time the market. During the past 40 years, when the market has average 9.87%, if you missed the 25 best days in the stock market (out of around 10,000 days with the market being open), your return would be at 6%, a little more than half the entire market.

When you look at how difficult it is to find winners or time the market, it is pretty easy to see it is better to be a passive investor and find a mutual fund that mirrors the market and invest your money and let it stay there. Even though that is the case, there still is some action you should take with your investments.

You do not want to try and time the market and find winners, but you do want to occasionally rebalance your investment portfolio. Goldie and Murray give an example on what this means.

The authors took a portfolio that was split into seven types of asset classes (U.S. large growth stocks, U.S. large value stocks, U.S. small growth stocks, U.S. small value stocks, international large growth stocks, international large value stocks and long-term government bonds) in 1990. Each asset class had a set percentage of investments in each group.

For one example, the authors just let the initial investment grow and decline every year for 20 years; for the other example, at the end of every year, the authors reset the percentages back to the initial set point. This means if one asset class had a good year, they would sell from that class and buy from an asset class that had a worse year.

Selling your winners and buying your losers may sound like a bad plan, but after 20 years, the portfolio that was rebalanced every year had a higher percentage return and was less risky.

It is tricky in the investing world to get a higher return with less risk, so this is very significant. Selling your winners and buying your losers may sound counterintuitive, but it really forces you to sell high and buy low. There will be years one asset class will outperform another, and by rebalancing you take your emotions out of the situation and enjoy the benefits of diversification.

If these last three articles made you think a little more about your investing, I strongly encourage you to get the book “The Investment Answer” by Daniel Goldie and Gordon Murray. It is a fairly quick and easy read and can help shape your investment strategy and possibly earn you thousands of dollars in the coming years by making wise investments instead of emotional investments.

Buy the book or check it out from your local library (which you can do in Sterling, when I get it back along with the fine I will need to pay — which was not a good personal financial decision considering I don’t make anything from writing this column).

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