By Dr. Scott Brown (Via Ezine Articles) – Debunking the 2% and 5% Prudent Investor Allocation Rule
My wife and I grew frustrated over the years watching index funds in our employee sponsored 401(k) plans grow but not fast enough. As a solution we decided to invest in single stocks in self directed Roths and additional individual 401(k) plans external to our employer sponsored retirements.
The problem we then faced was finding the right single stocks.
If you watch a popular investing T.V. show or subscribe to a typical investment newsletter you will receive the advice to never put more than 2% or 5% into any single investment – or something similar. Then the advisory service will work to spoon feed you a large menu of recommendations.
You are expected to pick between 20 to 50 different stocks.
I discovered a study by New York University Stern finance professor Andrew Metrick in 1999 entitled “Performance Evaluation with Transactions Data: The Stock Selection of Investment Newsletters” published in the #1 rated Journal of Finance.
Professor Metrick concluded that investment newsletter editors lost against a simple equity index fund. My frustration was heightened. I kept thinking…
There Must Be Another Way!
Insights and breakthroughs came overtime.
The most important was after I had been trading and monitoring a large number of advisory recommendations from many sources. This was before, during and right after the 2007-2008 crash. The silence of the newsletter editors was painfully disingenuous.
Each advisory services blindly recommended “buying opportunities” during the entire collapse. Not one recommended sitting it out in cash.
That told me that investment advisory services were completely out of touch with the major trend of the stock market in aggregate. It became clear to me that the blind guided main street in the investment advisory industry.
If you can’t trade you can always recommend.
The Land of Frequent & Bad Small Bets
Our accounts were now filled to the brim with lots of stocks enthusiastically certified “fantastic” by Wall Street investment newsletter services listed in the Mark Hulbert’s Financial Digest. I was also in contact with a lot of other subscribers due to my stature in finance.
Each complained about lackluster results from advisory service recommendations.
Ironically I was watching the accounts I helped steward with my sister-in-law double and triple in one stock after another. I didn’t have energy to frantically churn each account as the newsletter editors I followed recommended.
I was eagerly reading each new recommendation and hassling with lots of complicated buying and selling in small amounts.
Gains almost covered losses. It was like playing slots strapped to a treadmill in a dark and dingy downtown Vegas casino.
The whole time I was directing her entire account into whatever I felt most strongly was the best stock in the market at that time. When the share price up-trend weakened over time stops would scrape her out with a hefty profit every other year or so.
Her returns beat ours by a long mile. This did not please my wife.
She began demanding that I concentrate her portfolio. But I resisted.
Then the bomb fell. I had been working on an extensive study of newsletter returns.
I remember the day when professor Eric Powers of the University of South Carolina gave me the bad news. Our study also showed that investment newsletters did not beat the market.
The reason investment newsletters can never beat the market is because of prudent diversification. Let me explain.
Where Prudent Is “Stupid” and “Naive” is Smart
Advisory service editors are under the scrutiny of the SEC.
Their attorneys are terrified of the federal financial red eye of Sauron. Any investment newsletter editor that recommends that you invest 40% in one stock would be fired.
Yet this is exactly what Warren Buffet did with American Express stock in the 1960s. That concentrated investment became a blockbuster profit for Berkshire Hathaway shareholders.
Prudent diversification is a cocoon for incompetent mutual fund money managers with spotty stock picks. Even more peculiar is that it facilitates that a bad stock picking analyst or broker can become an excellent advisory service editor on Wall Street; with sufficient sales charisma.
Recommending lots of stocks spread out in small bets makes the bad blend out over time in average but harshly attenuated long-run returns.
It became painfully imperative to stop chasing 20 to 50 advisory recommended stocks that combined would never beat the averages. The constant churn bled my accounts in transaction costs and I really felt it.
I was better off naively diversifying in 500 stocks in one fell swoop.
Naive diversification is best accomplished by simply purchasing 1 indexed mutual fund. A good example is the Vanguard 500 Fund (VFINX).
It has low turnover and low fees. And it generates naive diversification across more than enough stocks to achieve full averaging.
In an employer sponsored 401(k) with no self-direction naive is smart diversification.
The 3 Stock Portfolio of Infrequent & Good Big Bets
My best advice to any family financial steward seeking high returns is to concentrate on no more than 3 stocks in your Roth and individual 401(k). But get the best of both worlds. Make sure you index your employer sponsored 401(k) – ours have grown surprisingly large despite the boredom.
They say that professors teach what they can’t do. Think again.
If John Maynard Keynes could become a millionaire in the stock market so can you!
Claire Emory. 2013. Do Investment Newsletters Move Markets? (Digest Summary). CFA Digest 43(3). 315-338.
Andrew Metrick. 1999. Performance Evaluation with Transactions Data: The Stock Selection of Investment Newsletters. The Journal of Finance 54 (5). 1743-1775.
How Diversification Nearly Killed Our Accounts!
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