2) The random walk theory states that someone who randomly picks stocks and holds on to them will do as well as someone who studies stocks and actively manages a portfolio, buying and trading "on knowledge." This observation is supported by many academic studies, including that of Nobel-Prize winning economist Dr. William Sharpe at Stanford University, who won the 1990 Prize in economics. It has been popularized by (among others) Burton Malkiel, a Yale Professor whose book A Random Walk Down Wall Street has gone through several editions since first published in the 1970s. Still, economics being what it is (the "dismal science"), you can always find studies to prove anything. It is certainly possible to beat the market, and year after year a certain percentage of people do (though they are not the same people year after year). They have a mixture of luck and, invariably, hard work ferreting out sectors that will outperform. The fact remains, most professional, highly paid money managers don't even match returns of the S&P 500 Index. In the period 1985-1998, the S&P 500 outperformed 80% of all actively managed stock funds. In 1998, 17.2% of actively managed general equity funds (excluding index and sector funds) outpaced the S&P 500. The only way this can happen is for most managed funds to do worse than the stock market average. Which is exactly what happens. Above all, don't get yourself embroiled in any debate with someone trying to sell you an actively managed fund. He or she will likely be twisting the facts to suit his/her purpose, and you will just as likely come out on the short end if you invest. Just remember: the market-beaters you hear or read about are after the fact; there is no guarantee they will do as well in the year or years after you invest your money. If you choose to branch out into a non-index stock fund, do it because you have researched the fund and feel comfortable with your decision, not because someone sold it to you. There are several reasons active managers by and large don't equal or beat the stock market averages. One is simply that everyone knows and trades on the same information. Thus it is almost impossible for a manager to learn more about stocks than the guy he wants to buy from or sell to. In the long run stocks go up when companies grow and boost earnings, and because stocks give a better overall return than prevailing fixed interest rates. During periods when interest rates are high, or company earnings fall, stocks go down. There are of course day-to-day, month-to-month, or year-to-year aberrancies, and these aberrancies do give some managers transient opportunities to "beat the market." But, ultimately, since for every buyer there is a seller, and vice versa, it is highly unlikely that any manager can outsmart his colleagues year after year. Some very rich investors have lost a lot of money signing on with a "hot" money manager, one whose next feat was to under perform the market because of speculative investments. Since everyone trades on the same information, then all other things being equal, over time one half of active managers should perform worse and one half better than the stock market average. So right off the bat chances are 50-50 that you will under perform the stock market by signing on with an active manager (i.e., buying an actively managed stock fund). But all other things obviously aren't equal, since more than 50% do worse than the market average. Several factors work against active managers. One is that, being active traders, they often try to time the market, which means investing heavily when they think the market will go up, and pulling back when they think it will go down. But experience shows that such "market timers" usually under perform because they miss sudden, unexpected rallies in the market. Another factor working against most active managers is that they try to divine which broad sectors are "hot" (e.g., technology, consumer goods, transportation) and shift money into them to catch the upswings. The problem is, sectors can turn on a dime, and no manager can continually guess the right trends. But perhaps the most significant reason active managers usually under perform the market has to do with fees, the cost factor of any investment.

3) Every investment, no matter whether it is a certificate of deposit or a U.S. Savings Bond, carries costs. You must pay someone for handling the transaction, for printing the paper, for writing brochures, for storing the account information, etc. Banks are housed in expensive buildings, paid for by profits on depositors' accounts. Salesmen and brokers are also expensive to the companies who hire them, and these people can only survive by making large profits on what they sell. If you are a naive investor (only in the sense you haven't learned much about different types of investments), you are at the mercy of sales people, brokers, real estate agents and advertisers who know much more about what they are selling than you do. And these people will naturally seek to take advantage of your naivete to make a large profit. This happens all the time; it is not illegal, it is not evil, it is just a reality of the market place. Now it stands to reason that the more money the sales person or broker or advisor makes, the less you, the investor, will make. If you invest $10,000 into a mutual fund with a 5% load, right away you are actually investing only $9500; you have to earn $500 just to break even. If your investment earns 10% a year and the financial advisor keeps 1% as his fee, you will only clear 9%; if the advisor keeps 2%, you will only make 8%, etc. After several years these "small percentages" add up to very major dollars. Fees are one major reason why most investors make less money investing with full service brokerage firms and financial planners (who all charge loads and/or high fees) than if their money simply tracked the stock market without the broker's commission (which is possible in an index fund). The large fees mean that the stocks or mutual funds have to out perform the market by a significant percentage in order to equal the market's return. And that is hard to do (see random walk theory, above). But make no mistake. There are fees in no-load funds and other products sold by discount brokers, though seldom to the extent charged by full-service brokers and financial planners. The average actively managed stock mutual fund charges 1.35% of assets per year; the average actively managed taxable bond fund 0.97%. That's a charge of $135 and $97 per $10,000 invested per year, respectively. By contrast, a typical stock index fund (one that tracks the market) charges less than $50 per $10,000 invested (.50%) and some much less than that. (It should come as no surprise that full-service brokers don't sell true index funds. The fees such funds charge are simply too small to generate enough of a sales commission.) Unless and until you feel yourself knowledgeable and sophisticated (i.e., know enough to speculate), don't buy any mutual fund with annual expenses larger than 1.35% (for a stock fund) or .97% (for a bond fund). The fees for all funds are listed in each fund's prospectus, and published on the internet in most cases. They are also published quarterly listings in the WSJ, and many other places. In other words, they are easy to find out, but first you have to ask. High fees are also one reason any purchaser of life insurance as an investment comes out poorer than buying term life insurance and investing the difference on his own. The huge cost of buying insurance through a sales person guarantees not only much higher cost for the insurance than otherwise, but also a poorer rate of return when compared to an investment without the thick crust of fees. So, what should you do? I will answer this question in Part 2.

Copyright © 1996-1999 Lawrence Martin, M.D.
Revised: March 1999