Scott Burns: The Better Monkey Solution

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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.

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.”

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.

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. 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 three-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.

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 five funds would beat comparable actively managed-fund portfolios 82 percent of the time over five years, 89 percent of the time over 10 years and 97 percent of the time over 25 years.

SCOTT BURNS is a principal of Plano-based investment firm AssetBuilder Inc. His e-mail address is scott@scottburns.com.

— Universal Uclick


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