The "Best of Both Worlds"? - There's No Such Thing!

Every once in awhile I come across a personal finance article that offers up shockingly bad advice which, if followed, would do much greater harm to an investor’s situation than it would to help them. A recent Forbes article does just that in claiming that there is a way to have “the best of both worlds” between actively and passively managed investment strategies.

As a passionate indexing advocate, my interest was piqued. The strategy is presented as follows: rather than invest in international stock funds, simply buy 10-30 foreign stocks according to the weightings of your favorite international mutual fund. The writer sums up the strategy’s “benefits” - “by avoiding the high fees of an actively managed fund, investors who buy a diversified portfolio of individual stocks are getting much of the same low cost advantage as index fund investors.” In reading that, I was speechless. Why recommend a much more difficult and costly strategy when it’s already been stated that your goal is to replicate the low-cost strategy of the index fund? Why not just buy an index fund?

Not only is this bad advice for obvious reasons – assets are being spread too thin and high transaction costs eat away at returns (the strategy is by no means low cost), it goes completely against the tenet that investors should keep investing simple. How is this strategy “the best of both worlds” when it so obviously involves actively managing your portfolio? After all, the investor is picking both the fund to replicate and the stocks to own when managing their money.

The writer even notes “owners of individual stocks also get the added advantage of being able to reduce their taxes by controlling when and how they sell individual shares. They can sell shares that have dropped in value, buy them back after 30 days, and then use the losses to offset other taxes.” Most of the individual investors I know have neither the time nor the patience to pull off such a bad strategy. Besides, indexing is inherently tax efficient which would negate any positive effect the above tax loss selling strategy would have over the low costs of indexing. Here’s a better idea then the one offered up in the article: buy an index fund and forget about everything else!

Ultimately, the article offers up no rational argument against indexing – the simplest and most efficient way to long-term wealth. Indeed, the article opens up explaining how indexers think:

Since you have no way of knowing which lucky manager will outperform, you're better off just buying the whole market and minimizing your fees with passive index funds. The evidence seems to largely bear this out as studies show that up to 80% of actively managed mutual funds underperform the market and that those that did outperform didn't tend to continue doing so over subsequent periods of time.  

The facts are all laid out for the reader. I’m at a loss for why people still try to justify owning actively managed funds – or an investor’s replication of an actively managed fund - provided there’s a passively managed fund that is considered an equal or greater representation of a specific area of the market as compared to the actively managed fund.

A World Without Soothsayers

Dictionary.com defines a soothsayer as "a person who professes to foretell events." Another name for this type of person is a prognosticator or clairvoyant, and I can't help but think that Wall Street is becoming populated more and more with these types of people and less and less with people who actually know something. In short, Wall Street is trying to sell you something that they shouldn't: their predictive power.

The problem with Wall Street analysts and strategists making predictions and claims is that they're never held accountable. They are free to predict Dow 36,000, economic malaise, food lines and the like without any system of checks and balances. After all, why should they have one? The people making these predictions get paid to make them and for the most part, get to keep their jobs even if they're wrong. Just like your local weatherman may think but never openly admit, "we have met the enemy and he is us".

All of this leads me to the question - what would a world without market soothsayers be like? If Wall Street's hype and prediction machine collectively ceased to exist, would things run more efficiently? For one, dissemination of facts and true information could be acted upon without the potential for personal judgment to be clouded by the opinions of others. It may sound like a perfect world, one in which Wall Street and the media have no ability to impact your investments. Indeed, it is a perfect world for all investors - it is the world in which we simply ignore what Wall Street's prognosticators are saying and enjoy our lives.

The More Things Change...

An old adage goes, "the more things change, the more they stay the same" and nowhere is this more applicable than on Wall Street. Many readers, especially those who came of age during the Internet era and subsequent dot com bubble, will remember vividly the days of dot com IPOs skyrocketing 1,000% or more in their public debut and frenzied day traders trying to get their hands on said shares. It's been over 10 years since we emerged from the dot com bubble and it appears as if a fresh bubble may be brewing...in Internet names. On May 18, LinkedIn, the business networking site, debuted and skyrocketed more than 80% during the trading day. Fresh on the heels of LinkedIn's debut, other Internet names like Groupon, Twitter, Facebook and Zynga are filing or expected to file for IPOs in the coming months. Some estimates peg Facebook's value upwards of $65 billion, larger than many major American companies. 


Is the Internet bubble back? Time will tell. The only constant is that the more things change on Wall Street, the more they stay the same.