APRIL 1 PROCLAIMED “INDEX FUNDS DAY” TO DRAW ATTENTION TO FOOLISH BEHAVIOR OF STOCK PICKING

April 1, Index Funds Day, is the ideal time to draw attention to the differences between active investment management and indexing – to illustrate why it is a fool's game to think one can outperform a market average or index given the unpredictability of news and randomness of stock market prices.

A consortium of top fee-only financial advisors, with almost $2.5 billion under management, has formed an alliance to declare April 1 Index Funds Day, and to expose what they believe is the biggest hoax played on investors every day – one to rival the BBC's 1957 Swiss Spaghetti Harvest hoax. The active money management "you can beat the market" hoax, however, is far more dangerous because it has fooled investors into thinking that their money managers can beat the market by forecasting the next news story that will move market prices. The fact is, news is random and cannot be predicted. Likewise, stock price movement is volatile, so picking stocks is largely a matter of luck, and success cannot be sustained over time.

Led by Mark Hebner, founder of Index Funds Advisors, Inc., the alliance is using this April Fools Day to showcase the foolishness of stock picking over index funds. Hebner points out that decades of research by top academics and Nobel laureates in the country continue to prove that index funds, which are based on efficient market theory, will preserve and enhance an individual's portfolio over the 30 to 50-year average investment lifetime. This is in direct contrast with stock picking which may deliver good returns in the short run but seldom, if ever, over time.

Consider this – research has shown that only 3% of active managers beat an appropriate index over a period of 10 years or more. In fact, Dalbar Research's 2009 Investor Behavior report showed that the average equity investor earned 1.87% a year, a sharp contrast to the 8.42% annualized return of the S&P 500 Index. This paltry return for the investor was actually -0.97% when inflation adjusted (inflation = 2.84%), and even worse if one considers that taxes owed on actively managed funds equal about 2% of the fund value. Do the math, it isn’t pretty.

Efficient market theory coupled with a careful matching of risk capacity and risk exposure, are the keys to successful investing, not speculation, Hebner notes. Active investors need to be aware that the expected long-term return on speculation is zero more often than not, minus their costs, which include commissions, management fees, margin costs, stock randomness and more.

History has shown that a diversified, tax-managed small-value-tilted portfolio of index funds will have better results than actively managed investments, which are higher risk and deliver lower returns over a portfolio's lifetime. Why is this important? Because close to 90% of individual investors actively manage stocks they pick themselves or they buy mutual funds where stocks are picked for them.

Most active investors don't think that gambling on tomorrow's news can be hazardous to their wealth, nor do they think seriously about the risks and costs associated with playing the market. They don't understand the free market principles that are the cornerstone of capitalism, or the important role that diversification plays in reducing the uncertainty of expected returns. Concentrating investments in one industry or country only adds risk and does not increase returns.

Mark Hebner is a terrific source on the pitfalls of active investing. In fact, he has developed a 12-Step Program for investors who are addicted to stock picking because he knows the odds are stacked against them for long-term success. You can review the 12-Step Program and related materials at www.ifa.com.

For more information, please contact.

Mark Hebner,
President
mark @ ifa. com

Mary Brunson,
Director of Marketing
Index Funds Advisors, Inc.
mary@ifa.com 

Index Funds Advisors, Inc.
www.ifa.com
19200 Von Karman Ave.,
Suite 150
Irvine, CA 92612
Toll Free: 1-888-643-3133
Local Phone: 949-502-0050
Fax: 949-502-0048

1. Market Randomness and Active Management: Markets are moved by news. News is unpredictable and random by definition. Therefore, the markets movements are unpredictable and random. However, this market randomness does have a positive average of about 10%/year because capitalism works. Active managers who have claimed to outperform a market average or index have also implied that they have the power to predict tomorrow’s news. But since it is impossible to consistently predict the future, the results of active managers are unpredictable and random. This concept is known as the Random Walk Theory and it was first discussed in The Theory of Speculation, a paper written in 1900 by Louis Bachelier. In 1964, MIT Professor Paul Cootner published a 500 page collection of research papers on the randomness of the market titled, The Random Character of Stock Market Prices. In 1965, Nobel Laureate in Economics and MIT Professor Paul Samuelson wrote his now famous paper, Proof That Properly Anticipated Prices Move Randomly. Also in 1965, University of Chicago Professor, Eugene Fama wrote his highly regarded papers, Random Walks in Stock Market Prices, and The Behavior of Stock Market Prices. After carefully reading this extensive collection of peer-reviewed research, you will be convinced of the randomness of stock market prices.

2. Skill or Luck: The average actively managed investment must underperform the indexed investment, when all costs are deducted. [source] Those actively managed investments that beat the indexed investments fail to consistently beat the index in the future. The reason for market beating performance in a random market is simply due to luck and not due to a skill that is repeatable. Research shows that only about 3% of active managers beat an appropriate index over a 10 year or longer period. Needless to say, it is nearly impossible to predict those winners in advance. Lucky investors are well advised not to expect a continuation of their good fortune. [see 1, 2, 3, 4, 5, 6, 7, 8]

3. Index Portfolios Best Capture Risk and Return: Actively managing your money will create higher risk and lower returns than a globally diversified, tax-managed, and small value tilted portfolio of index funds. Due to commissions, management fees, margin costs, taxes, stock randomness, and market efficiencies, you will slowly transfer your money into the pockets of stock brokers, mutual fund managers, hedge fund managers, and the many other individuals profiting from your numerous transactions and your lack of understanding of free market principles. Active management is hazardous to your wealth. A recent study by Brad Barber of the University of California, Davis, showed that 82% of the 925,000 active traders on one stock exchange lost $8.2 Billion/year from 1995 to 1999. Dalbar Research stated in their 2009 report on Investor Behavior that the average equity investor earned a paltry 1.87% annually for the last 20 years, compared to 2.84% inflation and 8.35% for the S&P 500 over that same period. The gap between the average active investor and the market is 6.48% per yr.The global equity total market value is $27.1 Trillion as of February 2010, so 6.48% of that is about $1.76 Trillion!

4. Returns from the Risk of Capitalism Rank Highest: Capitalism is a great idea that has worked for centuries. It has provided an annualized return of about 10%/year since 1926 and has the highest rate of return of all investments tracked over periods of 50 years or more. That rate of return is explained by the difference between the low risk of capital and the high risk of capitalism. It is not the result of speculating in short term price changes. There is no additional expected return from speculation above the average return. The gains from speculation are offset by the losses in any random situation, leaving the average, or the index, as the most likely return. This concept is known as a zero sum game. Investors earn returns from consistent exposure to the right risk factors, not from gambling on tomorrow’s news.

5. Market Efficiency Is Why Capitalism Works Better: The world’s stock exchanges facilitate a free market system that is the cornerstone of capitalism. These capital markets simultaneously price the cost of capital and the expected return from the risk of capitalism. Free markets perform this highly important task in the most effective and efficient manner because the knowledge of all investors exceeds the knowledge of any individual. Due to the millions of intelligent and highly competitive investors, it is unlikely that any individual investor will consistently profit at the expense of all other investors. From this we can conclude that free markets work and that current prices reflect the knowledge and expectations of all investors at all times. [more] This concept is known as the Efficient Market Theory. If free markets were not more efficient than controlled markets, like those in communist countries such as North Korea or Cuba, then the communists would be more prosperous than the capitalists. [more]

6. Cost of Capital and Expected Return for Capitalists: The expected return for a capitalist, equity buyer, or investor is equal to the cost of capital of the equity seller. An intelligent capitalist will estimate the expected return based on the risk of the equity, which is tied to the risk of the company. The higher the risk of the company, the higher their cost of capital, and the higher the expected return for the capitalist. The lower the risk of the company, the lower their cost of capital, and the lower the expected return for the capitalist. Those investors who carefully match their risk capacity with their risk exposure have the best chance of obtaining the long-term historical returns of the global markets. A buy, hold, and rebalanced risk exposure strategy is the best method to capture those returns.

7. Small Value versus Large Growth Companies: Public companies that are unglamorous, small, and relatively cheap (small value) are riskier and have higher costs of capital than those that are glamorous, large and relatively expensive (large growth.) As a result, a dollar invested in a Fama/French Index of small value companies in 1927 grew to $40,095 by the end of 2004 (14.6% per year), and a dollar invested in a Fama/French Index of large growth companies grew to only $1,154 over the same period (9.6% per year.) [more]

8. Diversify, Diversify, Diversify: Diversification is the investor’s best friend because it reduces the uncertainty of expected returns, otherwise known as risk, without changing the expected return. Concentrating investments only adds risk, and does not increase expected return. For example, any one stock in the S&P 500 has an expected return of about 10% per year, plus or minus about 50% two thirds of the years. However, the S&P 500 Index has the same 10% expected return, but it only has a risk of plus or minus 20% two thirds of the years. So 10% plus or minus 20% is far superior to 10% plus or minus 50%. Highly efficient portfolios of index funds have had returns of 14.3%/year with risks of 15.6% over the last 34 years, after fees (see Index Portfolio 100, which includes about 16,000 companies from 35 countries.) This is why buying the whole haystack (index) is better than looking for the needle (a stock) in the haystack. What is the risk and expected return of your portfolio, based on the same investment strategy over the last 34 years? [compare]

9. Selecting Index Funds: There are three major providers of index funds. Dimensional Fund Advisors, Barclays Global Investors and The Vanguard Group. Each company has index funds that track different indexes. Investors need to select a portfolio of index funds that maximizes their expected return for the risk they are accepting.

10. Peace of Mind: Don’t let your retirement years be tainted by the discomfort of poverty. Reliance on family members or government programs for your financial well-being will be a source of unhappiness, insecurity, and low self-esteem. The sooner you start saving and planning for your retirement, the better. A prudent and intelligently managed investment portfolio of index funds has the highest probability of providing security and peace of mind in the years when it will be needed the most.