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Many investors will focus on the wrong ball when making investment decisions for the New Year. For these investors, the light at the end of the tunnel could be a freight train.

The international and domestic stock markets were negative or flat in 2011. The S&P 500 Index had a paltry return of 2.11 percent, which made it a standout performer among major markets. There were some big winners in the stocks making up the Dow Jones Industrial Average. McDonald’s gained 34 percent, Pfizer was up 28.6 percent, and IBM gained 27.3 percent.

[See The 10 Best Places to Retire in 2012.]

Brokers are on their phones calling their clients with recommendations for next year’s winners. They are also dispensing their views about where the market is headed in 2012.

Here’s my advice: Don’t listen to them. They have no more ability to pick winning stocks than a chimpanzee tossing a dart at a board. If they really knew where the market was headed, they would have predicted the biggest recession since the Great Depression and the ensuing rapid recovery.

Instead of engaging in the discredited notions of stock picking and market timing, you should be eschewing all individual stocks and bonds and limiting your investments to a globally diversified portfolio of low management fee stock and bond index funds in an asset allocation (the division of your portfolio between stocks and bonds) appropriate for you.

While you may understand the importance of globally diversifying your stock holdings, doing the same with your bonds is just as important. Few investors appreciate that almost 75 percent of the global government bond market is composed of non-U.S. bonds. While average returns of U.S. and non-U.S. bonds may not differ significantly, there can be meaningful differences in annual performance. By adding non-U.S. bonds to your portfolio (assuming the currency risk is hedged), you can reduce overall volatility, which is one of the primary benefits of diversification.

[See top-rated funds by category ranked by U.S. News Mutual Fund Score.]

It used to be quite difficult for investors to obtain international diversification of the bond portion of their portfolio in a cost effective manner. That’s about to change. Vanguard recently announced the Vanguard Total International Bond Index Fund, which will be available early this year. The fund will have a low expense ratio of 0.4 percent for the investor share class. Vanguard recommends an allocation to international bonds ranging from 20 percent to 40 percent for the bond portion of your portfolio.

Another option for those seeking international bond diversification is SPDR Barclays Capital Short Term Fund (BWZ). This fund tracks the Barclays Capital 1-3 year Global Treasury ex-U.S. Capped Index, which consists of fixed rate, investment grade debt issued by foreign governments of investment grade countries. It has an expense ratio of only 0.36 percent.

[See The Best and Worst Sources of Financial Advice.]

The next time your broker calls and wants to discuss how the international monetary crisis could affect your investments, stop him in his tracts. Tell him you want to focus on broadly diversifying both the stock and bond portion of your investments. Ask him to recommend an international bond index fund or exchange-traded fund. Don’t be surprised by the stunned silence at the other end of the line.

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I hear a lot of concern about uncertainty in the market.  This is understandable.  Our domestic economy remains on thin ice, with dangerously high unemployment and record deficits.  The recovery is agonizingly slow.

The situation in Europe is even more dire.  The euro is on life support.  Greece, Italy and Spain all have troubled economies.  Even China is experiencing an economic slowdown.

The securities industry and the financial media have gone into overdrive in an effort to “explain” this uncertainty.  A typical observation is this one from J.D. Steinhilber in a blog on Seeking Alpha: “I think the environment in 2012 will remain challenging and highly uncertain.”  Mr. Steinhilber advises investors  “…that when you don’t really know what lies ahead, but you know there are major potential hazards, it is wise to proceed with caution.”  I believe this advice is dead wrong.

It is precisely because of the uncertainty in the market that investors are rewarded.  If there were no risk, there would be little reward.  Treasury Bills are perceived by investors to carry very little risk because they are backed by the full faith and credit of the US. Treasury. The latest return on a one year Treasury Bill is 0.12 percent.  Little risk.  Little return.

Higher risk investments (like stocks) have a greater uncertainty of outcome and wider ranges of short term volatility. The opposite is true for low risk investments.  They have narrower ranges of short term volatility. You can find a chart illustrating the relationship between risk and reward here.

Current  prices for stocks and bonds are fair.  They are determined by millions of willing buyers and sellers who are fully informed about news and forecasts of future events.  Efforts to find mispricings in stocks and bonds are unlikely to be successful.

Based upon the assumption that prices are fair, you can expect a risk-appropriate fair return over time. I am not suggesting that you will always get a fair return on your investments.  All we know is that the further the actual future return is from a fair return, the less likely it will be.

You can find a helpful chart showing probability distributions of investments at various risk levels here.

It is the uncertainty of returns that creates the expectation of a future positive return.  If there were no uncertainty, there would be little or no return.

The proper way to invest is not to “proceed with caution.”  It is to avoid emotions by being prepared for the random outcome associated with the risk of your investments. Well educated investors don’t try to predict the impact of future events on their portfolios.  Instead, they understand the trade-off between risk and return.  They invest in a globally diversified portfolio of low management fee index funds in an asset allocation appropriate for them.  They don’t fear uncertainty.  They expect it and embrace it as the source of their returns.

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Index Funds Advisors, Inc. (IFA) recently completed an analysis of the performance of state retirement pension plans which showed that all of them would have fared better with a portfolio of index funds such as the ones offered by IFA. When confronted with these numbers, the often heard refrain of the administrators of these plans is that confining themselves to stocks and bonds is far too limiting for funds that have billions to invest. Instead, they must search for “alternative investments” such as hedge funds and private equity that are not available to the general public. IFA has repeatedly cautioned “qualified” investors against being seduced by the notion that they are going to “beat the market” merely because they can hire talented managers in an asset class that allegedly has exploitable inefficiencies. One study that reinforces this warning is “The Performance of Private Equity Funds”¹ by Ludovic Phalippou and Oliver Gottschalg of the University of Amsterdam. The authors analyzed a dataset of 1,328 funds (including both U.S. and international funds) and corrected for the following three common practices that upwardly bias the reported returns of the public databases that track the performance of private equity funds:

1) The residual values reported by private equity funds long after they have made their last payments to investors have traditionally been counted towards their returns. The authors argue that these residual values should be zeroed out since investors normally do not collect any part of the residual value.

2) When calculating the performance of private equity funds as a group, the weights are often based on capital committed. The authors argue that a superior measure is the value actually invested since funds generally do not invest all their committed capital at the outset.

3) As with hedge funds, there is a strong selection bias in that successful funds are far more likely to report their results than failed funds.

After addressing all three of these issues, the authors found that private equity funds underperformed the S&P 500 by 3% per year. Adjusting this underperformance to account for the additional risk of private equity brings it to a substantial 6% per year.

This study deserves the attention of institutional investors such as foundations, endowments, and pensions. This study belies the often-made claim that managers and asset classes that are only accessible to “qualified” investors will provide outsized returns that are unavailable to the remainder of the investing public.

¹ Phalippou, Ludovic and Gottschalg, Oliver, “The Performance of Private Equity Funds,” The Review of Financial Studies, Volume 22, Issue 4 (April 2009), pp. 1747-1776.

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This past year was a difficult one for small cap stocks across all geographic regions, as shown in the table below:

Of the three equity risk premiums identified by Eugene Fama and Kenneth French¹, the size premium is the smallest, and thus the most vulnerable to attack. An article in the September 2011 issue of Financial Advisor Magazine² went so far as to declare that there never truly was a small cap premium and that large cap stocks are a superior investment to small cap stocks. As we will see below the small cap premium is alive and well, and small cap stocks have a legitimate place alongside large cap stocks in a diversified equity portfolio.

Before going any further, it is important to understand exactly what is meant by a risk premium. The presence of a risk premium implies that investors can expect a higher return as compensation for the bearing of risk. In the case of small companies, it is easy to understand that these companies should have a higher cost of capital than large companies which tend to have highly-valued assets such as widely recognized brand names and deep pools of employee talent. This higher cost of capital should be paid to investors in the form of higher returns.

Fama and French obtained a quantitative measurement of the size premium (SmB = Small Cap minus Big Cap) by sorting the US equity market into deciles based on size and assigning the five smallest deciles to the “small cap” classification. For the 84 calendar years from 1927 to 2010, the average value of SmB was 3.24% with a standard deviation of 12.92%. When we apply a statistical test (the t-test) to determine if chance alone could explain the magnitude of SmB, we find that the probability of that occurrence to be less than 5% (t >2). Furthermore, if we break up the 84-year period into the two pieces before and after the publication of the Fama/French paper¹, we find that the average value of SmB was 3.35% in the 1927-1992 period and 2.84% in the 1993-2010 period. Contrary to the expectation that the small cap premium would disappear once it was publicly exposed due to numerous investors acting on it and thus driving up the prices of small cap stocks, the small cap premium actually persisted.

One very important aspect of the small cap premium is the standard deviation of about 13%. A standard deviation of this size means that it would not be uncommon for small cap stocks to lag large cap stocks by 10% in a single year (a one standard deviation event which has occurred in 9 of the last 85 years). The two standard deviation event of small cap stocks lagging by 23% or more has only occurred twice (1929 and 1973) in the last 85 years. Small cap stocks have beaten large cap stocks in 47 (55%) of the last 85 years, and in the first 12 years of this millennium, small beat large in 8 years (67%).

Any argument regarding the inclusion or exclusion of small caps in an equity portfolio should consider their diversification benefits. As shown below, a simple blended large/small portfolio (in the same proportion as used in most of the IFA Index Portfolios) captured a 0.8% higher annualized return than large cap alone with a manageable 1.7% increase in standard deviation. Also visible in the chart below is the much higher volatility of small cap stocks, as the higher return of small caps comes with higher risk.

To summarize, the question an investor should ask is not “should I be in large caps or small caps?” but rather “what is a sensible blend of large and small companies that will allow me to capture a risk premium without being tempted to sell out of my portfolio when it performs differently from the Dow Jones Industrial Average or the S&P 500?” Having an exposure to small cap stocks is still worthwhile, but it should be in moderation.

1. Fama, Eugene F. and Kenneth R. French. 1992. “The Cross-Section of Expected Stock Returns.” Journal of Finance (47):427-465.
2. Gary A. Miller and Scott A. MacKillop. 2011. “Rethinking Small Caps.” Financial Advisor Magazine www.fa-mag.com/component/content/article/8289.html?magazineID=1&issue=175&Itemid=73

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Weston Wellington
Dimensional Fund Advisors

Equity investors around the world had a disappointing year in 2011 as thirty-seven out of forty-five markets tracked by MSCI posted negative returns. The US did well on a relative basis and was the only major market to achieve a positive total return, although the margin of victory was slim. Total return for the S&P 500 Index was 2.11%, and the positive result was a function of reinvested dividends—the index itself finished the year slightly below where it started.

Throughout the year, investors seeking clues regarding the strength of business conditions or the prospects for stock prices were confronted with ample reason to rejoice or despair. Optimists could cite the strong recovery in corporate profits and dividends, the substantial levels of cash on corporate balance sheets, low interest rates and inflation, a booming domestic energy sector, continuing strength in auto sales, and record-high share prices for leading multinationals such as Apple, IBM, and McDonald’s. Pessimists could point to persistently high unemployment, slumping home prices, tepid growth in retail sales, worrisome levels of government debt at home and abroad, and political gridlock in both Congress and various state legislatures.

Although the broad market indices showed little change for the year, there were opportunities to make a bundle—or lose one. Among the thirty constituents of the Dow Jones Industrial Average, thirteen had double-digit total returns, including McDonald’s (34.0%), Pfizer (28.6%), and IBM (27.3%). But losing money was just as easy: The three worst performers in the Dow were Hewlett-Packard (–37.8%), Alcoa (–43.0%), and Bank of America (–58.0%). If nothing else, the substantial spread between these winners and losers discredits the argument we often hear that all stocks are now marching in lockstep and that diversification is ineffective.

Achieving even modest results in the US market required more discipline than many investors could muster, since investor sentiment fluctuated dramatically throughout the year and the temptation to enhance returns through judicious market timing often proved irresistible.

For fans of the “January Indicator,” the year got off to a promising start as stock prices jumped higher on the first trading day, pushing the Dow Jones Industrial Average to a twenty-eight-month high. Bank of America shares jumped 6.4% that day, the top performer among Dow constituents. With copper prices setting new records and factory activity worldwide perking up, the biggest worry for some was the potential for rising prices and higher interest rates that might choke off the recovery. “Overheating is the biggest worry,” one chief investment strategist observed. By April 30, the S&P 500 was up 8.4%, reaching a new high for the year.

Stocks wobbled through May and June but strengthened again in July. On July 19, the Dow Jones Industrial Average had its sharpest one-day increase of the year, jumping over 200 points, paced by strong performance in technology stocks. Just a few days later, however, stocks began a precipitous decline that took the S&P 500 down nearly 17% in just eleven trading sessions. The century-old Dow Theory—a sentimental favorite among market timers—flashed a “sell” signal on August 3, and on August 5, Standard & Poor’s downgraded US government debt from AAA to AA+. As investors sought to assess the implications of sovereign debt problems in both the US and Europe, stock prices fluctuated dramatically, with the S&P 500 rising or falling over 4% on five out of six consecutive trading days in early August. Rattled by the sharp day-to-day price swings, many investors sought the relative safety of US Treasury obligations in spite of the rating downgrade, pushing the yield on ten-year Treasury notes to a record low. Stock prices hit bottom for the year on October 3 as some market participants apparently lost all confidence in equity investing. A Wall Street Journal article cited a number of individual investors as well as professional advisors who had recently sold all their stocks and did not expect to repurchase them anytime soon. “I feel like a deer in the headlights,” said one.

As it turned out, the article appeared in print on the second day of a powerful rally that sent the Dow Industrial Average surging over 1,500 points during the next 19 trading days, putting it back into positive territory for the year.

What can we learn from a difficult year like 2011? As Dimensional founder David Booth is fond of saying, the most important thing about an investment philosophy is that you have one. Many investors (as well as some allegedly professional advisors) apparently decided to switch from a buy-and-hold philosophy to a market timing strategy in the midst of an unusually stressful period in the financial markets. We suspect few of those adopting the change would have been able to clearly articulate their investing beliefs and why they had shifted.

Legendary investor Benjamin Graham offered the following observation nearly forty years ago: “There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part.”

Good advice then, good advice now.

Mark Gongloff, “Investors’ Forecast: Sunny With a Chance of Overheating,” Wall Street Journal, January 3, 2011.

Jonathan Cheng and Sara Murray, “Stock Surge Rings in Year,” Wall Street Journal, January 4, 2011.

Matt Phillips and E.S. Browning, “Tech Sends Stocks Soaring,” Wall Street Journal, July 20, 2011.

Steven Russsolillo, “‘Dow Theory’ Confirms It’s an Official Swoon,” Wall Street Journal, August 4, 2011.

Damian Paletta, “U.S. Loses Triple-A Credit Rating,” Wall Street Journal, August 6, 2011.

Tom Petruno, “Investors Stampede to Safety,” Los Angeles Times, August 19, 2011.

Kelly Greene and Joe Light, “Tired of Ups and Downs, Investors Say ‘Let Me Out’,” Wall Street Journal, October 5, 2011.

Benjamin Graham, The Intelligent Investor (New York: HarperCollins 1949).

The S&P data are provided by Standard & Poor’s Index Services Group.

MSCI data copyright MSCI 2011, all rights reserved.

Yahoo! Finance, www.yahoo.com, accessed January 3, 2012.

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The returns of hedge funds have trailed behind those of the S&P since 2003: 18% vs. 29% total returns, according to Simon Lack of SL Advisors in a Wall Street Journal “MarketBeat” article. The 2% management fee and 20% performance fee (20% of the fund’s profits) add to the wide spread between returns. The difference in returns could possibly be even wider, because hedge funds get to decide if they want to be included in databases that are tracked and analyzed. In other words, there is a selection bias.

The article presents another comparison: hedge funds vs. a corporate bond index, as measured by the Dow Jones Corporate Bond Index. The index has grown 77% since 2003, adding to a list of examples demonstrating the underperformance of hedge funds when compared to market benchmarks.

As Jay Franklin cited in a previous IFA article, “every major category of hedge funds (eleven categories) on average failed to provide a higher risk-adjusted return than the S&P 500 from 1995 to 2003. Only one category (emerging markets) provided a higher unadjusted return than the S&P 500.”

Lack credits the underperformance of hedge funds to the large influx of assets into hedge funds over the last ten years, followed by a dissipation of “alpha” or outperformance “as more managers chase after a limited pool of market inefficiencies.” Data from Hedge Fund Research shows that the amount of capital raised from 1998 – 2002 more than doubled to $820 billion.

Lack advises investors who have an investment time horizon of five or more years to invest in U.S. stocks rather than hedge funds and addresses this issue in his new book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good To Be True.

New standards and fee models are being considered by certain hedge funds, which could enable investors to keep more of their money.

For further information on hedge funds, read Jay Franklin’s articles:
“IFA’s Concerns with Hedge Funds” @ www.ifa.com/section/hedgefunds.asp
“Hedge Funds on Edge” @ http://www.ifa.com/articles/Hedge_Funds_on_Edge.aspx

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Dan Solin

As the New Year starts, you may be considering a change in your investing strategy.  There are so many purveyors of financial advice that it can be confusing to separate fact from fiction.  Here are my choices for sources of good advice, based on solid data.  Unfortunately, these sources are often overwhelmed by the far more abundant bad and downright ugly advice, so I will designate those as well.

Good Financial Advice

1. John Bogle:  I like all of his books, but my favorite is The Little Book of Common Sense Investing.
2. Burton Malkiel:  A Random Walk Down Wall Street is still an investment classic, although it can take some discipline to get through it.
3. Larry Swedroe:  A prolific author of thoughtful books, my favorite is one of his early ones: What Wall Street Doesn’t Want You to Know.
4. Mark Hebner, the President of Index Funds Advisors (ifa.com) (with whom I am affiliated) has just released a condensed, updated and revised version of Index Funds, The 12-Step Recovery Program for Active Investors. This book will be available on Amazon January 31, 2012. The foreword by 1990 Nobel Prize Recipient, Harry Markowitz, alone is worth the price of the book.  If the research in this book doesn’t persuade you to fundamentally change the way you invest, you are suffering from cognitive dissonance.
5. William Bernstein:  Perhaps the deepest financial thinker of our time, all of his books are superb.  Everyone should read The Intelligent Asset Allocator and The Four Pillars of Investing.
6. Taylor Larimore, Mel Lindauer, Richard A. Ferri and Laura F. Dogu:  The Bogleheads Guide to Retirement Planning tells you everything you need to know about planning for retirement.
7. I wrote the Smartest series of books to empower all investors to avoid becoming victims of the securities industry and to demystify the process.  I don’t hide information and my books are not written to generate advisory business.  I tell you exactly which index funds you can purchase on your own, directly from major fund families like Vanguard and Fidelity.  Start with The Smartest Investment Book You’ll Ever Read and move on to the others.
8. Allan Roth:  How a Second Grader Beats Wall Street makes it simple to understand how to invest intelligently.

Bad Financial Advice

There is so much bad financial advice, I can only use categories:

1. Retail brokers:  They can’t pick stocks, time the markets or pick “hot” fund managers, yet they spend their days dispensing advice in each of these areas.  Your chances of having a prosperous New Year are greatly enhanced if you cancel your retail brokerage account.
2. Discount brokers: It’s fine to use them for the limited purposed of buying low cost exchange traded funds.  If you are relying on the data they provide to assist you with research and analysis, or their trading programs, they are a source of really bad advice.  It is unlikely your trades will be profitable, net of your transaction costs.
3. The Financial Media:  Much of the financial media gives a forum to pundits who make predictions concerning the direction of the markets or particular stocks, bonds or mutual funds. None of this information is helpful to investors.  A chimpanzee throwing a dart is likely to be as accurate as these “experts.”

The Ugly

The advice given by those in this category is no worse than typical bad financial advice.  What makes their advice “ugly” is that they have been given a forum to widely dispense their views, and they abuse that forum by providing information likely to harm you.

1. Jim Cramer:  All you need to know about Cramer are the views attributed to David Swensen on ABC.  Swensen is the manager of the $34 billion Yale Endowment: “On ‘Mad Money,’ Cramer promotes a mindless short-term approach to markets by encouraging frenetic trading of individual stocks. Such a high-cost, tax-inefficient strategy almost guarantees failure.”
2. Jeff Macke:  Macke is a host on Yahoo’s Breakout.  He uses this forum to discuss his trading strategies.  He provides no data supporting these strategies.  Recently, he cautioned his readers against pursuing a “buy and hold” strategy.  I gave this blog my “worst financial blog of 2011” award.

If you want to increase your chances for 2012 to be not just happy also prosperous, you would be well advised to focus on good advice and avoid the bad and especially the ugly.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read and The Smartest Portfolio You’ll Ever Own.  His new book, The Smartest Money Book You’ll Ever Read, was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.