Can Picking the "Right Securities" Make Money in a Flat Market?

Last Updated Jul 14, 2009 7:53 PM EDT

Someone came to me recently with a letter he received via FedEx from a trust adviser. This apparently urgent letter -- from what I'll call the multi-billion dollar trustee "MegaTrust" -- focused on the near term uncertainty of the stock market. MegaTrust was willing to admit that it doesn't know where the stock market is going, but that was the only point we agreed upon. The concluding statement in the letter offers investors a learning opportunity. It went something like this:
We believe a continued targeted strategy selecting individual securities within equities rather than choosing the broadly allocated asset classes as a whole. We feel we can add more value in this environment by selecting the right securities rather than only broadly allocating capital.
What Megatrust claims
MegaTrust is trying to argue that it's easy to make money in an up market, and all but impossible to make money in a down market. In the flat market they're predicting, the only way to make money is to pick the right securities. On its face, it sounds somewhat logical. It's only when you stop to think about it that you realize their argument violates simple arithmetic. Let's pull back the curtain and take a closer look at this cheap talk.

Megatrust's misleading arithmetic
For the sake of argument, let's assume that the market will be completely flat over the next year. That is to say, investors can expect a big goose egg, as in zero percent, as far as return goes. Further, let's assume that the two percent annual expenses the average investor pays stay the same. What will the average investor earn? Arithmetic tells us that a zero gross return less a two percent fee yields a minus two percent return.

We are supposedly paying fees (though most investors have no idea it's two percent) for our professional to pick the right spot. Thus, MegaTrust is picking their securities while other multi-billion dollar pros, like mutual funds, are picking other securities. On average, their selections will zero out and they will return nothing to their clients, other than a minus two percent return.

It actually doesn't matter what the market returns, they will always in aggregate perform equal to the market before costs and about two percent less than the market after fees. Those professionals must underperform the Second Grader Portfolio no matter how the market performs. My MoneyWatch colleague Larry Swedroe discusses the math further in Do Current Conditions Favor Active Management?
The rest of the story
You may be thinking that a multi-billion dollar trust adviser with access to the best money managers in the world could actually earn its fee. While certainly not impossible, it isn't true in this case. I compared MegaTrust's actual performance to the "broadly allocated asset classes" they argued against in their letter. It comes as no surprise that MegaTrust's "securities selection" strategy significantly underperformed the low cost broadly allocated diversified strategy.

My advice
The letter from this trustee was meant to reassure and, on the surface, sounded plausible enough to do just that. And certainly anyone is free to make such statements, even if they do stand in opposition to the laws of simple arithmetic. The fact that mountains of data exists that show it hasn't worked in the past sure isn't going to stop them. So it's up to you to not fall for this sexy pillow talk.

First examine the logic of these statements. If the logic passes the first test, then it's time to ask them to show you their track record.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.