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A reporter recently asked me a question that stumped me. In response, I said, "I don't know."
"You're my hero!" he said. "No one ever says they don't know!"
Well, I do, and I think you should, too -- particularly when it comes to making certain investment decisions.
That's because investing, at its heart, entails a lot of uncertainty. Part of the uncertainty stems from investors' tendency to act on emotions rather than on cold, hard facts. Scores of studies of investor behavior have shown that investors often become overly exuberant and exhibit risk-tolerant behavior in up markets only to pull in their horns when the markets are in the dumps.
And even when you've done your homework on a security, it's usually impossible to say that it will definitely go up or down and by how much, particularly if it's a new company or operates in a volatile industry. To reflect that there's a range of outcomes for any stock, our equity analysts recently rolled out Uncertainty Ratings for the companies they cover.
For a similar reason, you should question any market prognosticator's ability to forecast a precise value for the Dow industrials ($INDU) by year-end or the direction of a given currency.
Think about the dizzying number of factors you'd have to get your arms around to correctly forecast the value of the dollar versus the euro by year-end. You'd have to have a pretty clear knowledge of where the U.S. economy was headed, of course, but you'd also have to draw a bead on the economic health of Europe and all other large economies, as well as interest rates, inflation levels and geopolitical factors such as the outcome of the U.S. election in November. If that seems downright impossible, you're right.
In a similar vein, I'd argue that there are no black-and-white answers to many investing debates, both the big ones (is it better to own individual stocks or mutual funds?) and smaller ones related just to your portfolio (should I sell the fund that just had a manager change?). You can stack the deck in your favor by investing based on where you think the preponderance of evidence lies -- but also put in place a slight hedge in case you're wrong.
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Here are some of the key debates where "splitting the difference" is apt to be the right course of action:
1. Index mutual funds versus actively managed funds. The debate about whether you're better off buying an index fund that passively tracks a market benchmark or buying one run by an active stock picker has been simmering for years. It's irrefutable that many active stock pickers don't earn their keep, and I've long said that you can do just fine with an all-index fund portfolio (or an all-exchange-traded-fund portfolio, for that matter).
By the same token, I don't think you'd go too far wrong if you stuck with top active managers such as the ones who populate Morningstar's Fund Analyst Picks list.
However, perhaps a better course of action is to do both, according to a recent study by the Vanguard Group. Based on an analysis of more than 200 million portfolio combinations, even those portfolios composed entirely of funds run by top managers exhibited an improved risk-reward profile when a dose of index funds (accounting for roughly 25% or so of the overall portfolio) was thrown in for good measure.
(Before you complain that Vanguard has a horse in this race, thanks to its indexing prowess, it's worth noting that it also fields scores of actively managed funds.)
These findings translate perfectly into real-world portfolio management. If you have a lot of confidence in your ability to pick talented managers (and your real-life investment results back up your assertion), go ahead and invest the bulk of your retirement portfolio -- that is, your 401(k) and individual retirement accounts -- in actively managed funds.
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At the same time, consider devoting at least part of your taxable portfolio to a broad-market index fund or ETF. Plain-vanilla index funds are extremely tax-efficient and can serve to counter the volatility associated with your active funds' holdings.
2. Stocks versus funds. As with the indexing-versus-active question, here's another debate in which the combatants often imply the decision is absolute: You're either with them or against them. Stocks are too risky and time-consuming, the fund geeks argue, whereas the stock jocks sometimes imply that funds are strictly for sissies.
True, an all-fund portfolio can make sense for investors who are in search of low- or no-maintenance portfolios. And I know many investors (including several in our stock-analyst ranks) who have generated healthy returns using all-stock portfolios.
For most investors, however, stocks and funds can coexist peacefully in a portfolio as long as they don't overlap too much. If you have an S&P 500 Index ($INX) fund, for example, it's probably unwise to also have a big position in ExxonMobil (XOM, news, msgs).
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