The Better Monkey Solution

Let’s call it the Better Monkey Solution. It will allow you to be your own portfolio manager.

I’m serious. Even if you think yourself permanently witless as an investor, you can do this. Two guardian angels, time and low expenses, will be on your side.

Many people are happy to declare their total incapacity when it comes to managing their own money. But they are dead wrong about their incompetence. You don’t have to be a card-carrying member of Mensa to take care of your finances. You don’t have to find your inner Whiz Kid. All you have to do is pursue low costs and simplicity. Do that and you’ll have a high probability of doing a better job than all those folks who use your money as their Mercedes payment.

What the Oracle says

Don’t believe me? OK. Then, listen to Warren Buffett  and his comment in the latest Berkshire Hathaway annual report:

“…the ‘know-nothing’ investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.”

Take a simple step

All you have to do is invest in low-cost index funds.

Take this simple step and you will be the better monkey. Almost automatically, you will beat the majority of the other monkeys (as statisticians view professional portfolio managers).

Want proof? Try this. The most recent evidence  comes from researchers Richard A. Ferri  and Alex C. Benke. Working at different firms, the two have done massive testing of randomly generated active management mutual fund portfolios—the computer equivalent of enlisting thousands of monkeys to make fund selections.

What the computer found

The basic idea is to measure the returns on these portfolios, rank order the returns, and see what percentage would have been able to beat a portfolio built with low-cost index funds that invested in the same proportions in the same asset classes. Ferri and Benke did this over time periods that ranged from five to 15 years and for portfolios that contained three, five and 10 managed funds.

The results suggest that a casual index fund investor (even one with no confidence) is very likely to beat a professional who picks active managers.

Passive beats active

Here are some of their findings:

• A portfolio of three index funds beat 83.4 percent of the active-manager fund portfolios over the 15 years from 1998-2012. Equally important, when the active-manager fund portfolio lost, its median underperformance was more than twice as large as the gain in the minority of times a actively managed portfolio beat the index In other words, the upside was smaller, and the downside was bigger, if you tried active investing.
• The longer the index fund portfolio was held, the greater the percentage of managed fund portfolios that it beat.
• When the number of funds in the portfolio increased, the index fund portfolio won somewhat more often. Over the 10 years from 2003-2012, for instance, a 3-index fund portfolio won 87.7 percent of the time. A 10-index fund portfolio won 90 percent of the time.

These results were obtained without considering any fees for building either the managed or index fund portfolios. The idea was to test how often a portfolio of actively managed funds could beat a similar portfolio of index funds. The absence of this expense opens two doors for individual investors:

• If you choose a paid adviser who builds index fund portfolios, you are more likely to get a superior performance than if you choose an equally paid adviser who uses actively managed funds.
• If you choose to build your own index fund portfolio, your chances of superior results will be even better because you’ll avoid the cost drag of the hired portfolio manager.

Different research, same results

If these results seem unlikely to you, you should know that two other research studies came to very similar conclusions. One, done by financial planner Allan S. Roth, concluded that index fund portfolios with 5 funds would beat comparable actively managed fund portfolios 82 percent of the time over 5 years, 89 percent of the time over 10 years and 97 percent of the time over 25 years. (See sidebar)

Sidebar:

How a Second Grader Beat Wall Street

If you’d like to learn more about what makes good (and simple) investing, Allan Roth’s 2009 book is a very good start and a must for any index investor’s library. Then again, if you want to keep things simple, this could also serve as your onlybook and you could devote more time to watching Sponge Bob, which contributed to his 2^ndgrade son’s success as an investor. Now available in paperback and kindle editions, the 245-page book explains why index investing is the solution and Wall Street investing is the problem.

Pages 92 to 102 are the pages directly related to this column. Here is the matrix of probabilities from his research on how actively managed portfolios with more than one fund suffer even poorer odds than one fund portfolios.

“How A Second Grader Beats Wall Street” on Amazon.com

On the Web:

Scott Burns, “The Universal Retirement Tool,” 5/31/2013

http://assetbuilder.com/scott_burns/the_universal_retirement_tool

Richard A. Ferri and Alex C. Benke, “A Case for Index Fund Portfolios,” June, 2013

http://www.rickferri.com/WhitePaper.pdf

Warren Buffett’s Annual Shareholder Letter http://finance.fortune.cnn.com/2014/02/24/warren-buffett-berkshire-letter/

Allan S. Roth’s website, “Dare To Be Dull”  http://daretobedull.com

Alan S. Roth’s book on Amazon.com                     http://www.amazon.com/Second-Grader-Beats-Wall-Street/dp/0470919035/ref=sr_1_1?ie=UTF8&qid=1393618862&sr=8-1&keywords=Allan+Roth

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Photo: Pexels.com

(c) A. M. Universal, 2014