Why Smart Investing Eludes Most Investors

Most people don’t obtain the highest possible return for their level of risk.

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The definition of smart investing is simple: Obtain the highest possible return for a given level of risk. But if you are like most investors, this process has eluded you. Here’s why:

  • If you are investing on your own, the process you are using is likely flawed.
  • If you are using a broker or adviser, chances are they are part of the problem and not the solution.
  • [See 50 Best Funds for the Everyday Investor.]

    It doesn’t help that most of the financial media encourages bad investor behavior. The message is that you should follow the financial news, do your research, and attempt to pick stocks and mutual funds that will outperform the markets. An endless stream of self-appointed financial experts engage in the prediction game. They freely dispense their views about the direction of the market, with no measure of or accountability for the accuracy of their musings. When they are correct, they are convinced they have special insight. When they are wrong, they shrug it off and move on.

    You are buffeted by conflicting views as you attempt to find advice that will make you a better investor. The number of options dreamed up by the securities industry doesn’t help. From gold to structured products and everything in-between, you are told there is a way to achieve high returns without increasing your risk—the holy grail of investing. But there is a better way.

    Manage your risk. The amount of your portfolio allocated to stocks is the primary determinant of your risk. The higher the percentage of stocks in your portfolio, the greater the risk, the more short-term volatility you will experience, and the higher your long-term returns. Focus on the allocation of your portfolio between stocks and bonds. You will find a good asset allocation questionnaire here.

    [See the top-rated Vanguard, Fidelity, and T. Rowe Price funds from U.S. News.]

    Avoid actively managed funds. There is big difference between hard data and the opinions of your self-interested broker or adviser. Over almost any 5-year period, between 60 percent and 90 percent of actively managed U.S. stock funds, international stock funds, emerging markets stock funds, and global fixed income funds underperform their category benchmark. Standard & Poors tracks the performance of these funds and compares them to their respective indexes.

    Avoid brokers. Maybe there are brokers who focus on your asset allocation and recommend a globally diversified portfolio of low management fee index funds. But I have reviewed thousands of account statements sent to me by clients and readers of my books and I have never seen one where this portfolio was in place. The harsh reality is that brokers recommend expensive, actively managed funds that are most likely to underperform their benchmarks. They give advice based on the false premise that they have expertise about stock and mutual fund selection or the direction of the markets. Simply stated, you cannot achieve your goal of becoming a smart investor if you are relying on a broker for investment advice.

    [See 6 Numbers Every Investor Should Follow.]

    Educate yourself. You can read each of these books in two hours or less. If you do, you will never be a victim of the securities industry and you will become a smart investor:

    The Smartest Investment Book You’ll Ever Read. Discount my bias in recommending a book I authored. Hundreds of thousands of readers have fundamentally changed the way they invest and become smart investors based on the specific recommendations in this book.

    The Little Book of Common Sense Investing, by John Bogle. This is a succinct, easy-to-read, and easy to implement investing book by the co-founder of Vanguard.

    Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.