I have to be practical. I don’t believe anyone should rely on brokers or investment advisers who claim to be able to “beat the market” for investment advice. However, the reality is that 90 percent of individual investors ignore this admonition, often to their detriment.
If you insist on using these brokers or advisers, here are five questions you need to ask them. When you get the answers, you may be persuaded to fundamentally change the way you invest:
1. Can you predict the future? My guess is your broker did not predict the crash that started in 2008, or the ensuing recovery that continues to this date. If he could not predict these major events, why are you relying on him to predict the direction of the markets or the “target price” of any stock?
2. How risky is my portfolio? Every investor should be concerned about risk, yet few understand the risk of their portfolio. Risk is measured by “standard deviation,” which calculates the historical volatility of a stock or a portfolio. A low standard deviation indicates a low-risk portfolio. Conversely, a high standard deviation means your portfolio is risky. You should know the standard deviation of your portfolio. Few brokers know how to calculate standard deviation. William Bernstein, the author of The Intelligent Asset Allocator, had this sage advice for investors: “If your broker is not familiar with the concept of the standard deviation of returns, get a new one.” Better yet, get an adviser who focuses on your asset allocation and who recommends only a globally diversified portfolio of low-cost index stock and bond funds.
3. Why are there individual stocks and bonds in my portfolio? Individual stocks and bonds have the same expected returns as the index to which they belong, but far more risk. I don’t understand why anyone holds them. With an individual stock, you have risks unique to that company (like fraud or the death of key officers). When you purchase the index, you diversify away that risk. Why do you want more risk without the likelihood of higher returns?
4. Why do you believe some stocks are “good values”? There are millions of traders buying and selling stocks every day. They all have access to the same information. They incorporate that information into the price of the stock. There are no mispriced stocks. They are all fairly priced, through the collective wisdom of the market. If your broker is telling you a stock is a “great buy,” ask him what he knows that millions of other traders have missed. Does he believe all the sellers on the other side of the trade are misinformed?
5. How does the performance of my portfolio compare to that of a globally diversified portfolio of low-cost stock and bond index funds of similar risk? Be sure to get this comparison in writing, and be certain the comparison is to a portfolio of “comparable risk.” It’s highly unlikely that, over the long term, an actively managed portfolio of stocks and bonds, or one consisting of actively managed mutual funds, will equal or beat the returns of the index-based portfolio. I suspect your broker will refuse to give you this information.
Investing your hard-earned money is a serious responsibility. You need to educate yourself so you can assess the quality of the advice you are receiving.