Investment counselor Larry Swedroe joked recently that the financial crisis offers enough lessons to fill a doctoral seminar. With apologies to Larry and begging the indulgence of readers, whom I don't wish to scold for errors and misjudgments (heaven knows, I've made loads myself -- and not just the past year), here's my twist on Swedroe's syllabus.
1. Where's the money? You'd better know -- literally.
The Bernie Madoff affair and other fleece jobs should put to rest the notion that you can get rich from unpublicized investment opportunities unavailable to mere mortals. These secret deals frequently turn out to be Ponzi schemes or other scams.
If you give any adviser discretion to buy and sell investments without your prior go-ahead, you must demand to know where your money sleeps. As a client, you should get a monthly, if not online and real-time, statement of all positions and balances. If the statement contains a name you don't recognize, ask for details.
Many advisers extol private real estate deals or oil and gas partnerships. Describe the properties, please: locations, addresses, photographs.
If you're an investor in a package of mortgages or business loans, do you know who the borrowers are? Investors in something called Agape World thought they had a piece of well-screened business loans that paid as much as 16% with nary a default. The loans and the interest payments proved to be fakes, and the investors lost more than $370 million.
2. You're taking more chances than before -- even if you don't know it.
There's a neat graphic called the "Pyramid of Risk." At the base of the pyramid are such no-risk investments as bank savings and Treasury bills. The next level has high-grade corporate and municipal bonds and blue-chip stocks.
As you climb, you'll see small-company stocks and junk bonds and real estate. In the attic, you have such things as leveraged closed-end funds, emerging-markets bonds, commodities and options and futures.
One of the unfortunate side effects of the financial crisis is that practically every investment has become riskier than it used to be.
For example, money-market mutual funds are not quite the ironclad investment they've always been touted to be. High-quality corporate and municipal bonds have shown they can fall by double-digit percentages. Blue-chip stocks are capable of losing half their value in a year.
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Then -- and here's a lesson from the meltdown -- push everything except bank deposits and T-bills up one notch and recalculate the result. You may find that that low-risk portfolio you think you have is actually medium-risk, and that medium-risk portfolio is actually high-risk. Act accordingly.
3. The era of superstar fund managers is fading.
As a writer and editor for Kiplinger's, I'm guilty of lionizing managers such as CGM's Ken Heebner, Legg Mason's Bill Miller, Bob Olstein of the Olstein funds and Ron Muhlenkamp of the Muhlenkamp fund for delivering dazzling returns in good times. All of them are smart, hard-working professionals. But in almost every instance, money managers who stay around long enough eventually see their performance regress toward the average.
And, after years of sublime results, the path toward average can be deadly. Miller, after beating the market for 15 straight years, cost his shareholders dearly last year by sticking with financial stocks too long. As good as Heebner has been at divining the market's hot sectors, he couldn't help his CGM Focus fund avoid a loss of nearly 50% last year.
The more actively managed funds implode, the stronger the argument for indexing, particularly if we're in the middle of a long period of sideways or down performance from stocks. At the very least, you know that you'll pay minimal expenses with an index fund, and that's one of the few things in investing you can control.
If you want to make bets on some geniuses, invest the bulk of your assets in index funds and exchange-traded funds and put actively managed funds at the periphery of your portfolio.
Continued: The long-short of it
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