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Connect These Dots to Try to Improve Your Returns

Daniel Solin

Sometimes it's necessary to piece together seemingly unrelated news items to come up with an intelligent, evidence-based plan for investing. This was definitely one of those weeks.

Here are three such news items. By connecting the dots, you may be able to improve your returns:

Dot No. 1: The odds against picking "winners." Recently, an investor explained to me his process for selecting "winning" stocks. He buys stocks when "those he respects" tell him it's a good idea to do so. I asked him whether there was any peer-reviewed support for his system. He looked at me blankly.

The reality is there is an overwhelming amount of credible evidence demonstrating the daunting odds against beating the market by purchasing undervalued stocks. The latest evidence comes from a study, "New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods," released this month by the prestigious Pensions Institute at the Cass Business School, which is part of City University London. The study looked at the monthly returns of 516 mutual funds based in the U.K. between 1998 and 2008. It found these funds underperformed the market by an average of 1.4 percent for each year during this period.

The study also found that, of the fund managers examined, only 1 percent generated superior performance in excess of operating and trading costs. However, according to one of the paper's authors, David Blake , professor at the Cass Business School, those fund managers extracted the excess returns for themselves as fees, "leaving nothing for investors."

If this is the track record of highly sophisticated, professional fund managers who have extensive resources at their disposal, why do individual investors persist in the discredited practice of stock picking? The only rational explanation is collective cognitive dissonance.

According to Motley Fool writer Morgan Housel, cognitive dissonance is "one of the most powerful theories in behavioral psychology." It describes the practice of ignoring data to justify behavior you inherently know is wrong. To demonstrate, Housel uses the example of a hypothetical investor who puts $1,000 on a penny stock, loses everything and justifies his behavior by telling himself that he was just investing for entertainment.

Dot No. 2: Using brokers. The Financial Industry Regulatory Authority (FINRA) announced that it levied a fine of $8 million against Merrill Lynch, Pierce, Fenner & Smith. According to FINRA, the brokerage firm failed to waive mutual fund sales charges for some charities and retirement accounts. Merrill Lynch was ordered to pay an additional $24.4 million in restitution to affected customers. The firm had already repaid more than $64 million to the harmed investors.

The customers affected were approximately 41,000 small business retirement plans and 6,800 charities and 403(b) retirement plans. Participants in the 403(b) plans included ministers and employees of public schools.

Merrill Lynch's conduct after it learned that it was overcharging these customers is particularly chilling. According to FINRA, the firm became aware of these significant overcharges in 2006. Did it immediately make restitution? Did it report its conduct to FINRA?

Au contraire. It continued to overcharge its customers and did not report the issue to FINRA for more than five years.

This all-too-common ethical lapse is the latest, but not the only, reason you should refrain from relying on brokers for investment advice.

Bill Bernstein is a financial theorist and author of the seminal books, "The Intelligent Asset Allocator and The Four Pillars of Investing." His most recent contribution to financial literature is a superb 27-page e-book entitled: "If You Can: How Millennials Can Get Rich Slowly." Bernstein advises his readers to avoid "at all costs ... any stockbroker or full-service brokerage firm."

Dot No. 3: Special problems with retirement accounts. Often, brokers giving advice to retirees have an obvious conflict of interest. If the retiree elects to keep funds in the 401(k) plan, the broker will lose out on fees and commissions that can be earned if the account is transferred to his firm. It's not surprising that many brokers confronted with this ethical dilemma resolve this conflict in favor of their own economic interest, to the detriment of the retiree.

This conflict would not exist if a rule proposed by the U.S. Department of Labor were implemented. The rule would require brokers and other advisors to act in the best interest of the client during rollovers. Currently, brokers are permitted to recommend investments that are "suitable" for the investor, even if those investments are not in his or her best interest. Registered investment advisors, on the contrary, are always held to the higher fiduciary standard and can only recommend investments that are in the best interest of their client.

You will not be surprised to learn that this "no-brainer" of a proposed rule is being strongly opposed by the Securities Industry and Financial Markets Association, a trade association representing brokers and other members of the securities industry.

Here's the takeaway from connecting the dots among these three stories:

-- Limit your investments to a globally diversified portfolio of low management fee index funds, exchange-traded funds or passively managed funds in an asset allocation suitable for you.

-- Do not rely on brokers or full-service brokerage firms for investment advice.

-- If you are thinking about rolling over a 401(k) plan, rely only on the advice of a registered investment advisor who is required to act solely in your best interest.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book, "The Smartest Sales Book You'll Ever Read," has just been published.

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