The Successful Investor Today by Larry Swedroe is one of those books you can read again and again and still gleam a new nugget of wisdom. Millions of investors lose money because:

1. They paid too much for great companies

2. They believed that the road to wealth was fast and easy

3. They were caught up in the media hype

4. They were misled by the analysts' recommendations

5. They didn't know how the markets really worked

Larry Swedroe will unclutter your mind and get you back on the road to prosperity. We'll spend the whole week learning the 14 simple truths of investing.

I hope you visit the forum often and join in when you're so inclined.

Sheryl Sostarich

Truth 1: Active investing is a loser's game

As Jim Cramer shouts repeatedly, Stop Trading!

1. The average actively managed fund has underperformed the passive benchmark by 1.8 percent yearly on a pretax basis.

2. Past performance of an active manager is a poor predictor of future performance.

3. Expenses reduce returns on a one for one basis.

4. Turnover reduces pretax returns by 1 percent of the value of the trade.

Investors who bought emerging markets funds after the spectacular run-up in the '90s were awash in losses when economic turmoil roiled the market in Russia, Indonesia, Turkey, and Mexico.

Why is John Bogle a strong advocate of index funds? Becuase trading costs and illiquidity cause active managers to underperform the market.

A study by Buron Malkiel and Alek Radisich clearly refuted the claim that indexing influences equity prices.

Index funds outperform actively managed funds when the market rises. When markets rise, index funds stay fully invested whereas active funds hold more in cash for liquidity and trading purposes.

Index funds outperform actively managed funds during periods when large cap stocks outperform small cap stocks.

Index funds outperform actively managed funds during periods when investors are proportionately adding more money to index funds.

Why am I not surprised by these outcomes?

Sheryl Sostarich

Truth 2: The past performance of an actively managed fund is a poor predictor of its future performance.

A study by Financial Research Corporation found that most statistics have no predictive value:

1. Morningstar ratings are ineffective at finding funds with the potential to outperform in the future. In other words, don't be dazzled by the stars!

2. Past performance isn't predictive of future results.

3. Turnover and manager tenure are equally useless as predictors.

4. Asset size has little correlation to future performance.

5. Increasing net sales is actually a contrarian indicator. Investors tend to buy into mutual funds just before the returns of these funds turn mediocre to poor.

The more successful a fund is, the more lilely its future returns will worsen. The more a fund diversifies, the more it looks like and performs like its benchmark index. This is known as a closet index fund. A manager tries to beat the benchmark by concentrating the fund's assets into a few stocks. Most of these funds fall to the bottom of the rankings.

How does a mutual fund work?

The funds starts out with a small amount of assets, which it invests in little known small-cap stocks. The fund sizzles and cash inflows pour in, leaving the fund manager in a quandry as to what to do with the new money? Should he diversify the fund, concentrate the fund into a few small-cap stocks, or style drift to large-cap stocks.

An investor who buys a closet index fund is actually paying a premium for a fund that closely resembles the index fund. The more a fund diversifies, the harder it is to overcome bid/ask spreads, commissions, or taxes on capital gains.

The manager who uses the cash inflows to buy larger positions in a few small-cap stocks is hurt by high turnover as well as high market impact costs due to the illiquidity of small-cap stocks.

The manager who style drifts into large-cap stocks finds it extremely difficult to outperform the benchmark. All that there is to know about large-cap stocks is priced into the market so no one manager will have an advantage over another.

Sheryl Sostarich

Truth 3: If skilled professionals don't succeed, it is unlikely that individual investors will.

Larry Swedroe tells the amusing story of two fund managers. In 1995 Minneapolis-based money manager Robert Markman bet Vanguard's John Bogle twenty-five dollars that he could beat the market over the long term with a portfolio of professionally managed mutual funds.

For the five year period ending in 2000 Markman's funds trailed the Vanguard S&P 500 Inex Fund by an average of 6 percent per year. After the Nasdaq collapsed in March 2000, Markman bet another five dollars that he could beat the index with an even more aggressive portfolio of funds. Two years later, Markman's funds turned in an even worse performance at which time Markman admitted, "I've really become disillusioned with the ability of active managers."

I can't speak for you but a $25 bet seems to me like pretty low stakes for two high profile money managers.

Sheryl Sostarich

Truth 4: The interests of Wall Street and the financial media are not aligned with those of investors.

Financial journalist, Patrick Regnier of Money magazine interviewed hundreds of money managers to try to determine why some succeed while others fail. His insights were published in the August 2000 issue of Money.

1. Every financial publication Regnier could name: Money, Fortune, Smart Money, Forbes has dismally underestimated some managers while overhyping others.

2. A list of the magazines' favorite managers of five years ago now reads like an obituary.

3. Most fund managers are very smart. Unfortunately, so is the competition.

4. A manager's skill matters less than the trend he is riding or failing to ride.

The interests of publishers, broadcasters, and advertisers are not aligned with those of their readers or viewers. They are not about creating wealth. They publish or broadcast sensational stories that spur investors to buy and sell for the wrong reasons. It's not easy, but investors do need to filter the noise.

Sheryl Sostarich

Truth 5: Risk and reward are related: great companies provide low expected returns.

Growth stocks behave much like long-term bonds. When interest rates go up, long-term bonds fall steeply. Similarly, when inflation heats up, growth stocks sell-off because of declining earnings.

Growth stocks are long duration assets. Their price is based on a future earnings forecast. Value stocks are short duration assets. Their price is based on liquidation value and a current quarter earnings forecast.

Growth stocks have more price risk than value stocks. If anything goes wrong -- a sales shortfall, an earnings shortfall, competitive pressure, or product delays -- these stocks drop like a stone.

It is the perception of low business risk that causes the price of growth stocks to be elevated. It is high prices that create the high price risk in longer duration growth stocks.

It is the perception of high business risk that causes the price of value stocks to be depressed. It is low prices that create the low price risk in shorter duration value stocks.

Sheryl Sostarich

Truth 6: The price you pay matters.

One of the worst mistakes an investor can make is to pay too much for growth stocks. To achieve spectacular returns, you must buy stocks when others are fearful.

To achieve spectacular returns, high prices must accurately reflect a low perception of risk as well as low expected returns.

Investors need to occasionally adjust their investment strategies as capital market returns impact their portfolios. Following a period of high returns, it is prudent to sell overvalued stocks.

It's not prudent to hold out for a bear market so that your future returns will be higher. That is to say, be careful what you wish for.

Expected returns are not guaranteed returns. Don't recklessly deplete your resources.

Sheryl Sostarich

Truth 7: The most likely way to achieve above average returns is to stop trying to beat the market.

A common truth that Wall Street doesn't want you to believe is that by earning market returns, you will earn greater after-tax returns than the average investor. This is because the average actively managed fund underperforms its benchmark by 2 percent annually on a pre-tax basis. Stated another way, if you earn market returns, you will outperform the average investor and that includes professional investors.

What if everyone bought index funds?

There will always be some trading activity due to the exercise of stock options, estate settlements, mergers and acquisitions. Even if individuals stopped trading stocks, companies would still be active in trading other companies. With less liquidity, trading costs would rise, thereby increasing the margin by which passive investors trump active investors.

Sheryl Sostarich

Truth 8: Buying individual stocks or sector funds is speculating, not investing.

A study by William Goetzmann and Alok Kumar found that a majority of investors owned portfolios that produced low returns and exposed them to high risk.

1. Their portfolios were comprised of less than 5 stocks

2. Only five percent of investors held at least 10 stocks

3. Their holdings were usually concentrated in the same asset class

The lack of diversification caused the portfolios of these investors to be three to four-times more risky than a well-diversified portfolio.

The average investor had unrealistic expectations of how the market would perform and moreover, how his or her individual portfolio would perform.

The average investor is overconfident of his or her ability to select stocks that would outperform the market.

A poll conducted by the Wall Street Journal in June 1998 found that the average investor expected the market to return 13.4% in the coming twelve months. The longer a trend goes on, the more convinced we are that the trend will continue forever.

Why do investors believe they can outperform the market by purchasing sector funds? Because they incorrectly assume that the market has mispriced an entire sector.

Investors mistakenly believe that they can achieve diversification by buying several different mutual funds from the same fund family. This does not achieve diversification because the same holdings are often in mutiple funds managed by the same family.

Sheryl Sostarich

Truth 9: Reversion to the mean of earnings growth rates is one of the most powerful forces in the universe.

A study in 1982 by Richard Harris tracked the five-year earnings forecasts for over 6,000 publicly traded companies to determine why there was a persistent overvaluation of equities.

1. Earnings forecasts were too aggressive: analysts were overestimating profits by 7 percent per annum.

2. Low profit forecasts had a low margin of error. High profit forecasts had a high margin of error. There was less margin of error in forecasting earnings for large cap companies.

3. Most errors were from individual company forecasts. A smaller margin of error came from overestimating industry profits.

What motivated analysts to set their earnings targets so high?

1. Positive forecasts brought in more retail banking income.

2. Analysts were afraid to publish negative reports for fear of losing management's confidence.

3. Analysts chose to align themselves with management to win more investment banking business.

You will note that this is the opposite of current day forecasting. The enactment of Sarbanes Oxley has leveled the playing field: no one analyst has an edge over another. Analysts are reluctant to set their estimates too aggressive for fear that a company will miss its target, causing a massive bailout.

There is a strong tendency for profits to revert to the mean. Analysts were generally too confident in a company's ability to sustain high profits over the long term (that is, five years or more). When profits reverted to the mean (at a rate of about 40 percent per annum) and companies fell short of estimates, investors returns suffered miserably.

The truth is, equity prices can't grow faster than the economy forever. For the forty year period ending in 1980, pretax profits rarely exceeded 10 percent of GDP. There is a limit to the impact that falling interest rates can have on stock prices just as aggressive earnings forecasts aren't sustainable forever.

Why do investors overpay for growth stocks? They base their buy decisions on unrealistic estimates.

Sheryl Sostarich

Truth 10: The forecasts of market strategists and analysts have no value, except as entertainment.

If economists were smart they would never make forecasts. If they have to make a forecast, they should never give a number. If they have to give a number, they should never give a date. In that way, they can never be proven wrong.

A study by William Sherden, author of The Fortune Sellers, concluded that:

1. Economists cannot predict turning points in the economy.

2. Economists forecasts are no more than educated guesses.

3. No economist is consistently accurate with his or her forecasts.

4. Quantitative models do not improve forecasting ability.

5. Consensus forecasts do not improve forecasting accuracy.

6. Forecasts are affected by psychological bias, whether an economist is optimistic or pessimistic.

Likewise, stock analysts get paid a lot of money to help investors make the right buy and sell decisions. There are generally no reliable differences between the returns of the most highly rated stocks and the returns of those stocks least favored by the analysts. Outperformance generally occurred in the small-cap stocks. Mr. Sherden found that meteorologists had better predictive powers than market analysts.

Wherein we think we can predict the direction of the market, we can only do so in hindsight.

Sheryl Sostarich 

Truth 11: Taxes are often the largest expense that investors will incur.

Looking at a thirty year investment horizon, income taxes can reduce pretax returns by as much as 60 percent.

The average turnover of actively managed funds is close to 100 percent per annum. To materially reduce the negative impact of taxes on returns, the turnover must be reduced to 20 percent or less.

Taking Vanguard's lead in 2000, the SEC began requiring mutual funds to disclose after tax returns as well as pretax returns. A study by Charles Schwab found that, over the long-term, the average large-cap fund lost a hefty 14 percent of its returns to taxes while the average large-cap index fund lost only 6 percent of its returns to taxes.

How do tax managed funds reap greater returns?

1. By maintaining low turnover

2. By avoiding the realization of short-term gains

3. By selling stocks that have fallen below cost to offset gains in other securities

4. By selling appreciated shares with the highest cost basis

5. By trading around dividend dates

Sheryl Sostarich

Truth 12: Knowledge of financial history is critical to successful investing.

One of the most respected economists, Robert J. Shiller, explains why investors largely ignore the signs of an investment bubble?

1. The Internet led us to believe that we have a knowledge advantage.

2. We are overly bullish on America.

3. Increased materialism fueled the demand for stocks.

4. Changes in the political climate (i.e. reduced capital gains taxes) favored business and investing.

5. The media instilled portfolio envy for those "missing the boat."

6. We are being misguided by overly optimistic earnings forecasts. In late 1999, seventy percent of stocks had buy recommendations; only 1 percent had sell recommendations.

7. Mutual fund advertising convinced us that we needed to own stocks.

8. Low inflation gave us the illusion of greater real returns.

9. Reduced trading costs and twenty-four hour trading made it easy to jump in and out of the market.

10. There was a general rise in speculation.

Sheryl Sostarich

Truth 13: Adding international assets to a portolio reduces risk.

A study published in a 1998 edition of the Journal of Investing compared various allocations of the S&P 500 Index and the EAFE (Europe, Australia, Far East) Index

1. Any combination of the S&P 500 Index and the EAFE Index outperformed either index individually, a result of low correlation.

2. Increasing the international allocation to as much as 40 percent increased returns and reduced risk as measured by standard deviation (volatility).

3. An allocation of 40 percent international produced the highest Sharpe Ratio, a measure of the excess return over short-term Treasury bills.

4. Increasing the international allocation to 20 percent reduced the likelihood of negative returns by one-third.

5. Investors with a 10 percent international allocation could be 98 percent confident that they would reduce risk by raising the international allocation.

6. Investors with a 22 percent international allocation could be 90 percent confident that they would reduce risk by raising the international allocation.

Sheryl Sostarich

Truth 14: There is no one right portfolio, but there is one that is right for you.

An investor's ability to take risk is a factor of his or her time horizon as well as the stability of earned income.

An investor's willingness to take risk is a factor of his or her ability to ride out bear markets and stick to his or her investment strategy.

An investor's need to take risk is determined by his or her financial goals and the need to achieve desired returns.

Should you own fixed income securities in your portfolio?

Academic research has found that while investors have been compensated for the risk of owning long-term bonds, on average the relationship has broken down beyond 2 to 3 years. Hint: A fixed income investor who is seeking the highest return over a thirty-year period should buy a two to three year note and roll it over vs. buying a thirty year bond.

1. Holding one-month U.S. Treasury bills provides a risk-free rate of return (historically 6 percent) with a standard deviation of 1 percent per annum.

2. Extending the maturity to one year increases risk-free returns by 1 percent while increasing the standard deviation by 2 percent.

3. Extending the maturity to five years adds only 0.4 percent to returns, yet the standard deviation increases by more than two-thirds to 6.3 percent.

4. Extending the maturity to twenty years causes returns to fall 0.2 percent, yet the standard deviation almost doubles again to 11 percent.

I hope that Larry Swedroe's The Successful Investor Today has dispelled some myths of investing and given you encouragement to further pursue your financial goals. 

Sheryl Sostarich

Hi Robert:

Thank you for your question pertaining to the returns of active investors. Larry Swedroe's book has a definite bias towards passive investing. He openly praises the investing style of John Bogle and downplays the outstanding records of Peter Lynch, Bill Miller, and John Templeton.

A reader asked me offline, what about the returns of professional money managers such as Lee Kopp, Steven Leuthold, or Richard Perkins who manage portfolios for high-worth individuals, do the investing styles of these managers beat the market? I responded by saying, the book does not provide statistics for these money managers.

In fact, the book leads you to believe that those of us with an active investing style can't beat the market. I am not overwhelmed by this argument and continue to manage my own portfolio for high total returns.

I encourage you to read The Little Book That Builds Wealth by Patrick Dorsey. This book will give you helpful tips on active investing. I plan to discuss this book in the After Hours Book Forum later this year.

Sheryl Sostarich