An Investor Protection Plan

It is sickening to witness the continued fleecing of investors. If you are using a retail broker, or relying on much of the financial media, you may be a victim. Protect yourself.

Insist on Peer-Reviewed Data

There is data and then there is peer-reviewed data. Much of the data you receive from brokers and hear or read in the financial media is not peer-reviewed. While peer review does not guarantee accuracy or reliability, it means the information being disseminated has gone through an evaluative process to determine whether or not it is suitable for publication. You can find an extensive list of leading financial journals here.

The next time you get a stock picking, market timing or manager picking recommendation (which is the daily grist of many brokers), ask the person giving you this advice to provide a peer reviewed article indicating that he is following a methodology with a demonstrated history of success. You won't receive one, but the deer in the headlights look will at least make this exercise entertaining.

Don't Fall for Cherry Picked Portfolios

Everyone knows that past performance is not predictive. Why then do brokers so often rely on the short term past performance of fund managers as the basis for making recommendations? A very common trick used by brokers is to recommend a portfolio of stocks, bonds and mutual funds (or a combination) which has outperformed relevant benchmarks over a designated period of time. A few minutes with the right software can easily produce a portfolio with stellar returns. When confronted with this type of proposal, ask your broker to represent in writing that this portfolio was actually in his clients' portfolios for the entire period of time for which the returns are illustrated. Don't bother checking your inbox for a response.

Focus on Risk

Every investor should be concerned with the risk of their portfolio. Yet, in my experience, few are. Whenever I use the words "standard deviation," which is a measure of risk, I can see a glazed look come over my prospective client. Here's a simple guide everyone can follow. The calculations are based on the annualized standard deviation of monthly returns for Index Portfolios over 84 years from Jan. 1, 1928 to Dec. 30, 2011:

  • Very aggressive investors (100 percent stocks) should have a standard deviation that does not exceed 23 percent;

  • Moderate investors (60 percent stocks/40 percent bonds) should have a standard deviation that does not exceed 13 percent
  • Conservative investors (Up to 35 percent stocks/ 65 percent or more bonds) should have a standard deviation that does not exceed 8 percent.
  • Debunk Their "Expertise"

    A broker who loses a client to index funds typically responds with a dismissive statement indicating that he and his firm have the ability to select "market beating" fund managers. As discussed above, ask him to show you a peer reviewed article demonstrating the reliability of his methodology. In addition, ask him to provide you with a long term (10 years or more) analysis comparing the returns of the proprietary mutual funds of his firm (funds that have the name of the firm as part of the name of the fund) with their Morningstar assigned benchmark. After all, if they can pick superior managers, wouldn't those managers be running their branded mutual funds? This is another report you are unlikely to receive.

    There is an easier way to avoid becoming a victim. Don't use any retail broker or adviser who tells you they have the ability to "beat the markets".

    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.