All CFPs Come From Lake Wobegon

It’s amazing how two people can read the same article and come to completely opposite conclusions. A couple days ago, I mentioned a study by Arizona State professor Hendrick Bessembinder that likened individual stocks to lottery tickets. The study itself looked at all stocks from 1926 and concluded (among other things) that 58% of individual stocks failed to outperform 1-month Treasury bills over their lifetimes. That last part is key. Any stock can have a good day, good month, or good year. Bessembinder pointed out that over half of them do not perform well over their lifetimes (years). Enter your typical financial advisor. For a fee, they’ll reallocate your portfolio every year (or month!) using their super-secret formula to ensure you only have the winner stocks, and you can beat the market average (but only with the advisor’s help). The catch is, you have to beat the average by more than the advisor’s fee PLUS the added trade costs PLUS the additional capital gains taxes you’ll pay.

Bessembinder’s final conclusion was that your typical investor is better served by index funds. As an economist who understands the efficient market hypothesis and many other studies that have the same conclusions, I simply added Bessembinder’s study as another data point supporting index funds. Lauren Rudd read it and decided to channel his inner Lake Wobegon CFP… don’t you know, they all earn above average returns! Rudd claimed some secret unpublished method to construct “portfolios capable of outperforming the S&P 500 index over a 3, 5 and 10-year timeframe.” Anyone can do that with historical data. If, on Feb 5th, Dan Quinn had today’s knowledge of Bill Belichick’s play calls from Feb 5th, the Lombardi Trophy would be in Atlanta.

The saying goes “past performance is not indicative of future performance.” Market returns are essentially random, and anyone who says otherwise is trying to sell you something.

When financial planners face an uncertain future, rather than using known historical returns, their performance rarely lives up to the bluster. Academic studies consistently show the majority of brokers and financial planners underperform the market in the long run. Just last month, the Wall Street Journal reported on academic research showing that 82% of all U.S. stock mutual funds have trailed their respective benchmarks over the last 15 years.

Rudd also claimed that other advisers recommend closed-ended (ETF) index funds. That’s a total straw man argument. Brokers might recommend ETFs (good commissions and/or fees), but everything I’ve read (including my own book) says to use open-ended, low cost (<0.25%) index funds. This will provide higher after-tax and after-expense returns to the majority of investors.

 

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