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How to Invest in Stocks Smartly

NEW YORK (TheStreet) -- Larry Swedroe is on a mission: Save investors, one at a time if necessary. To spread his gospel, Swedroe writes investing books and is director of research at Buckingham Asset Management in St. Louis. But his missionary work doesn't end there: He is a cyber-Cassandra, sending missives to Web sites such as Index Funds and Vanguard Diehards and, yes, to journalists' email addresses. His message: Forget the stuff that Wall Street, the media and the mutual-fund industry peddle; the best route to long-term financial success is through low-cost passive investments such as index funds and exchange-traded funds.

Swedroe has a new book hitting the shelves this month, The Successful Investor Today: 14 Simple Truths You Must Know When You Invest. "The basic premise of my book is that the tremendous losses that investors had experienced were avoidable, and it had nothing to do with timing the market," he says. "This catastrophe was totally avoidable. People have only themselves or their advisors to blame."

For this week's 10 Questions, we've modified our format slightly to accommodate Swedroe's gospel: Instead of 10 Questions, we have 14 Truths, in Swedroe's words. When you hear what he has to say, you may better understand his passion for the subject. Who knows, maybe a few more investors will be saved.

Truth 1: Active Investing Is a Loser's Game

The arithmetic of active investing proves that, as a group, all active investors must earn the same return as active investors. All stocks must be owned by someone.

If you understand that basic principle, you will understand why active investing is a loser's game. Let's say you're in a two-stock world: Microsoft (MSFT) and General Electric (GE). You and I each have $100 in each stock. You decide GE's going to outperform, and I decide Microsoft's going to outperform. You want to buy GE, so where do you buy? You buy it from me. To do so, you have to sell Microsoft. Let's say Microsoft goes up 20% and GE goes up 10%, so they end up with an average market return of 15%. You did worse because stock underperformed.

Collectively, you and I get the same return as John Bogle, who decided to simply build an index of the two stocks. However, on a net basis, he has to have higher returns because he has no middleman to pay -- he pays no broker fees, no trading costs; he only pays a very modest expense ratio. What this simple exercise proves -- and Bogle has written on this, co-opting some of William Sharpe's work -- is that all investors, on a gross basis, must get the same return.

If the market goes up 15%, passive investors owning Vanguard's Total Market index fund of a total market exchange-traded fund get 15%. If you invested in the S&P 500 over past 75 years, you got 10%. It's a zero-sum game. But active investing is not a zero-sum game. It is a negative-sum game -- just like gambling. Net, we end up negative, because the bookies take their cut. The bookies -- market-makers, commissions, etc. -- collectively, they make it certain that active investing must be a loser's game. Active investors must underperform.

Now, if you change the plus-15% return to a minus-15% return, what does that do to the average of all investor returns? Nothing; they still end up getting minus 15% on average. That shows one of the great myths to be a lie -- that active investors do better than passive investors in a down market.

Active investing clearly doesn't work among large-cap stocks -- because the market is so efficient among large-cap stocks that you can't exploit any new information. Anyone who says that active investing works in large-cap stocks should wear a big shirt that says either "I cannot add," or, "I'm lying." There are only two explanations.

Substitute large-cap stocks for emerging-market stocks or small-caps stocks, and active investing still doesn't work -- even though there may be some operational inefficiencies to exploit. Here's the reason that's true. I'm not saying information efficiency doesn't exist. It comes down to costs: The more efficient the market is, the less it costs. In the small, less-efficient information market -- small-cap stocks -- it's possible you'll find something other people don't know. But the bid-offer spreads are wider; the costs of obtaining the information are greater. In emerging markets, where there's probably some information advantage, you pay a lot to get that advantage, and the higher costs essentially offset the advantage.

This proves active investing is a loser's game. Some can win. The only question left is, can you identify ahead of time the very few people that are actually going to win?

Truth 2: Past Performance of Active Managers Is Not a Good Predictor

Let's start with the old coin-flipping contest, where the object of the game is to flip heads consistently. If you have 10,000 coin-flippers, odds are you'll get 5,000 who pass the first round. The next flip it goes to 2,500, then 1,250, then 625 after four tries.

When this happens in the stock market, we are quick to call the coin-flippers who beat the market geniuses, when it could be luck. Why take the chance of it being luck when you don't have to -- you already have index funds that beat an increasing percentage of fund managers with each passing year?

Who was the best money manager of the 1970s? Not Fidelity Magellan. It's David Baker of 44 Wall Street fund. So, let's say investors saw that performance on the 1970s and put their money in Baker's fund. Well, 44 Wall Street was the worst-performing fund of the 1980s, it lost 73%.

Now, today a lot of people point to Bill Miller at Legg Mason Value -- he beat the S&P 500 12 years in a row, right? Well, it may be skill and it may be luck. We don't know for certain.

In the book, I write about the Larry Swedroe Investment Trust, which has a higher return than Bill Miller's fund going back 15 years. How did my fund manage to beat Miller and the S&P 500? Well, since my wife's name is Mona, my lucky letter is "M." I construct a value-weighted portfolio of all stocks that begin with the letter "M" and rebalance annually. Now, I made up that fund, it was created by data mining. But the great returns were purely a matter of chance, yet people would put a ton of money in the Larry Swedroe Investment Trust if they could.

Most people are highly risk-averse, yet they continue to take unnecessary risk by putting money in actively managed funds.

On a risk-adjusted basis, the numbers are far worse than people think. Over 10-year periods, the people who outperform the market on an after-tax basis, although you can't identify them ahead of time, they outperform by about 1% a year. The people who underperform do so by 3% a year. But the key point is, there are 11 times as many losers as winners.

You have this problem: If you win, you win by a little. If it's David Baker, you lose a lot.

Truth 3: If The Skilled Pros Don't Succeed, Why Should You?

All academic evidence points to this: The pros can't beat the market. Why should you think you can? Here's my analogy, which is borrowed from a scene in the movie Tin Cup. Let's say Steve Schurr gets the chance to play a round of gold with Tiger Woods.

On the fifth hole, you hit a lousy shot and get stuck in the brush with two trees between you and the green. Tiger is so unlucky that the wind blows his ball away and it lands right next to yours. Now, you both have two options, try to hit it through the sliver between the trees and onto the green, or play it safe and hit it back on the fairway.

Tiger decides, I think I can just squeeze it between the two trees. He tries once, and hits a branch. The ball rolls back. He tries eight more times and fails. On the 10th try, Tiger hits the ball just right and it goes between the trees and lands right in the cup.

Now, what's the winning strategy for Steve Schurr? The best in the world succeeds one in 10 tries, do you think you can make it? No rational person would try to make that shot. Only an irrational person who lets his ego get in the way would say, "Hey, Tiger made it, why can't I?"

It's the same thing in the stock market. If anyone could beat the market, it should be the largest pension plans in the U.S. These plans invest with people we don't even have access to, and all kinds of great research, regression analysis and so on.

FutureMetrics studied pension plans for 15 years, from 1987 to 2001. Of the 213 plans now in the study, only 19 beat a simple 60% stocks/40% bonds asset allocation. Did some succeed? Yes. About 10% succeeded. That's like Tiger Woods. You have a 90% chance of failing.

There's not a single thing you can do to find the great managers that Goldman Sachs, Merrill Lynch and Frank Russell thought of already. Frank Russell boasts that they can find these great fund managers. They get paid big money to do this. So they got the great idea to create mutual funds. Every year I've run Russell funds against passive-fund managers Dimensional Fund Advisors. Amazingly to me, I would've thought a 50-50 game would happen. I have never once seen this -- they lose and they lose badly.

What's the most inefficient asset class in the world? Emerging markets. Frank Russell's emerging-markets fund lost 7.8% on a pretax basis, DFA lost 1.4%. Russell's Large Value fund lost 3.5%, DFA's gains 3.7%. When you look at it after-tax, the results are even more stark.

As I say in the book, because of taxes, the risk-adjusted odds of beating the market are 38 to 1.

Truth 4: The Media Needs People to Tune In

For people in the financial news media, passive investing is boring, because you have to tell them the same thing every day. Tell them to buy low-cost index funds, then you have to tell them the same thing the next day and the same thing next month.

The media do what's in their interest. The winning strategy for them is the losing strategy for you. I watch CNBC with the mute button unless a Jeremy Siegel or some other professor with something interesting to say comes on.

For investors, there are three conflicts of interest. First, Wall Street: They make more money from 1.5% than by giving you index fund. Second, the media. Third, many advisers think they have to justify themselves to get a fee. "If I take you're money and put it in passive vehicles," they say, "then what do you need me for?"

Back to the media, remember: Don't confuse information with knowledge. Every time you hear something, ask yourself: Do I know this information before everyone else, and can I gain some advantage by knowing this?

Truth 5: People Confuse Great Companies With Great Investments

People never seem to understand this point, even though it's a simple one. So I'll give an example of something they understand: real estate. Let's say you can buy two properties in Manhattan; both cost $10 million and pay rent of $1 million a year. One is on 52nd and Park, the other is in the worst section of Bedford-Stuyvesant.

Which is less risky? Park and 52nd. In the real world, you would get to pay the same amount for something that offers considerably less risk -- and you wouldn't get this opportunity in the stock market, either.

But it must be so that the safer investment has a lower return. Let's use Wal-Mart (WMT) and J.C. Penney (JCP) as an example. If you could buy either company for $20 billion, which would you buy? Wal-Mart! They have a better management, greater financial strength and history of consistent growth. If they were both priced at $20 billion, every single J.C. Penney investor would sell his stock and buy Wal-Mart.

Less risky companies -- great companies -- must have lower expected returns. And those companies have much better earnings. Companies with great earnings are less risky. The only way you can get higher returns is if earnings turn out to be much greater than expected.

Think of it another way: If Wal-Mart and J.C. Penney go to the bank, who gets to pay a lower rate? Wal-Mart. The bank is willing to accept a lower rate because it's less risky. Why should it be possible that the equity would get a higher rate of return?

Truth 6: The Price You Pay Matters

The higher the price you pay for a stock, the lower the returns will be. Studies have shown that when the price-to-earnings multiple is above 22 on average, the stock's returns are less than 5%. When you buy a stock with a P/E below 10, the stock's return is about 17% on average. I talk about this in my book.

Higher prices don't necessarily mean the market is mispriced, but higher prices always mean lower future returns.

In the 1950s we lived in a high-risk world. We just ended the Second World War, we had the Soviet Union to worry about, and people didn't have very much confidence in the stock market. By 1990, we had no more war and no more Soviet Union, we were on good relations with China. By 1995, things looked even better. Eventually, prices got to be irrational. The problem is investors panic in both ways -- on the upside and the downside. People may have overreacted to Sept. 11, but we didn't know that was going to resolve itself OK.

Truth 7: Wall Street Deliberately Confuses Average Returns With Market Returns

The market, the media and money management firms confuse the market returns with average returns. I know: You don't say to your children, "I hope you grow up to be average."

Fidelity's founder Johnson says, "I can't believe investors want to accept average returns." Here's the key point: Market returns aren't average returns. If you accept market returns, you are guaranteed to beat the average investor collectively. It must be so. All you have to do is stop trying to beat the market.

If the markets are efficient, then no management is better than good management. The competition is the market, and the market sets a tough bar to beat. If you aim for market returns, you have much better odds. You won't beat everybody, but you'll beat an ever-increasing group.

Truth 8: Buying Individual Stocks Is Speculating, Not Investing

Individual stocks are much riskier than an individual portfolio. Let's say you buy a big block of IBM (IBM) because you think it's going to outperform. Are you sure it's going to beat the market? Can everyone be right that their stocks will outperform the market? No.

From 1957, when the S&P 500 was created, to 1998, only 74 of the original 500 components remained. Some were merged out of existence, but others went bankrupt. Now, of the 74 that remained, guess how many of them managed to beat the index? Twelve. If that doesn't convince you of the difficulty in beating the market with individual stocks, I'm not sure what else to tell you.

Let's look at the 1990s, that great decade for investors. Twenty-two percent of all stocks that survived the decade lost money -- and 5% of all stocks disappear every year! Here's the problem. People think of stock returns as normally distributing. They're not. One Microsoft that earns 10,000% offsets a lot of losers. The only way to ensure you get Microsoft is to buy all of them. One-third of all stocks underperform riskless fixed-income instruments -- why take that risk?

One other way to consider the issue: turtle eggs. A female turtle lays thousands of eggs, and predators eat almost all of them. But the only way to ensure survival is to lay all of them. Do you think you can pick the one turtle egg in 10,000 that will survive?

Furthermore, individual stocks have gotten much more volatile, meaning you have to own more of them to achieve diversification. If pharmaceutical stocks such as Merck (MRK) and Pfizer (PFE) have a high correlation, you only have to own two or three to get diversification in the sector. If they have a low correlation, you have to own them all.

Buy buying individual stocks, you lower your odds of achieving your financial goals.

Truth 9: Reversion to the Mean

In order to justify high P/Es, you have to have abnormally high growth. Robert Haugen wrote about this. In order to justify high-growth stocks, they have to post outsize growth for seven years; it only happens for four years on average.

Reversion to the mean with stocks averages 40% a year, according to Fama-French studies. The bigger the profit growth, the more incentive there is to enter.

You would think the market would incorporate this information, but it doesn't -- we had the Nasdaq 1000 trading with a P/E of 250 in 2000. If you have a stock that trades at an price-to-earnings multiple of 80, if you're growing at about 80% for 10 years, then you're OK. But no large-cap stock that ever traded above a P/E of 50 justified its valuation. Only 3% to 4% of all stocks justify that level, and they are mostly small-caps.

Truth 10: Forecasts Have No Value Except for Entertainment

Studies have found that economic forecasts have no real predictive value. Forecasts from the Federal Reserve, the Congressional Budget Office and the Council of Economic Advisors were worse than random forecasts, yet they have a real impact on the markets.

The basis of any forecast about the market begins with an economic forecast. If you can't get the economic forecast right, you can't get market forecast right.

Truth 11: Taxes Are Often the Largest Expense

Taxes are insidious, because they're small costs every year. People don't see after-tax returns so they don't think about them.

Nonetheless, taxes average about 3% a year. Compound 3% a year for 30 years and see the damage it has on your retirement. Taxes chew up almost 60% of your returns.

Now, what can an investor do? Clearly, passive funds are more tax-efficient, such as ETFs or even active tax-managed funds. People need to pay more attention to taxes: If you lose 1.5% a year in expenses and 3% a year in taxes, which is bigger? Taxes! Focus on them.

Truth 12: Knowledge of Financial History Is Critical

People think the bubble of the 1990s was different this time. It wasn't different, except that it was the Internet this time. I demonstrate in my book that if you just changed the names from JDS Uniphase (JDSU) and the rest to the electronics companies of the 1960s, it was exactly the same bubble -- same P/Es of 200, same IPO frenzy, same bursting and all the scandals that followed. People say, "Don't burst my bubble." I won't, but the market will.

People all said the Internet would change the world. These technology-inspired booms are remarkably similar. If individuals knew their financial history, they would have been wise to what was happening in the late 1990s. I mean, we had daytrading back in the 1700s!

Truth 13: Investors Confuse the Familiar With the Safe

Investors all over the world think you're country is the safest. We don't know if the U.S. is the safest market in the future. If you were 100% positive, Sept. 11 should've convinced you otherwise.

Your job, your livelihood, is tied up in the U.S. The prudent thing to do is to put as much as 40% of your money in international markets. It's hubris to believe otherwise.

This is one area where Jack Bogle and I disagree. He thinks you get all your international exposure from domestic stocks. I guarantee you if Bogle lived in Japan, he'd say you only need to own Japanese stocks. The data very clearly shows, if you look at long history, you get similar returns and lower volatility by diversifying with international holdings.

Even if you think the U.S. is highly likely to outperform, are you certain?

Truth 14: There's No One Right Portfolio, There's One Right for You

Most people don't develop their own strategy when it comes to investing, which is crazy. Can you imagine starting a business without a business plan?

When considering the right portfolio for you, it isn't just about risk tolerance, it's about the stability of your job, your ability to deal with tracking error -- when the market is way above or below your expected rate of return -- and your age/investment horizon. Of course, nobody cares about positive tracking error, which is silly, because that should get you thinking about negative tracking error. In 1998 and 1999, people who built a diversified portfolio would have had terrible relative returns. You have to stay the course.

-- Written by Stephen Schurr

This article was written by a staff member of TheStreet.

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