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3 Reasons You're Being Set Up to Fail

According to a survey conducted by Prince and Associates during the recent financial crisis, four out of five high-net-worth investors were planning to take money away from their financial advisors.

Does that surprise you? It shouldn't. Here's why.

The odds are stacked against you ...
... especially if you have money invested with some mutual fund conglomerate you saw advertised on TV. And, as you're about to see, the cumulative damage to your long-term wealth can be devastating.

Today, I'd like to share three reasons why investors like us have been set up to fail. Plus, why I'm convinced the stakes have never been higher, and why the mantra, "You can't make money buying and holding stocks anymore" is nonsense.

If you agree that what I say makes sense, I've got an alternative you can consider. So let's start with the No. 1 reason why most U.S. investors fail.

1. Thinking inside the box
You've probably seen the Morningstar style box -- the nine-box grid that shows whether a mutual fund invests in large-cap, mid-cap, or small-cap stocks. And whether the focus is on growth or value -- or some blend of the two. OK, fine. Except for one thing.

It seems to me that the more the style box was used to classify fund managers, the more they pigeonholed themselves (and us) into an investment style. To see how much this might be costing us, consider the path chosen by renegade investor Peter Lynch at Fidelity Magellan Fund. For 13 years, his investors earned 29.2% per year.

Lynch did it by thinking outside the style box. Sometimes he'd stock up on growth, other times value. Were he running Magellan today, I imagine he'd as likely look at an under-siege Intel (Nasdaq: INTC  ) as a resurgent Ford (NYSE: F  ) . He'd be as happy to get you into stodgy large-cap Procter & Gamble (NYSE: PG  ) as tiny Chinese agricultural company Yongye International's (Nasdaq: YONG  ) latest secondary offering.

In short, Lynch was a financial mercenary who refused to be hemmed in by some "box." That's how he doubled his Magellan shareholders' money in less than three years -- then did it again and again for 13 years. That kind of courage is hard to find today, which brings us to the second reason we've been set up to fail.

2. Following the herd
Why anyone would imagine that "following the herd" could make them money in this market is beyond me. But I can tell you (in six words) why professional money managers do it: Picking stocks is a lonely business.

If you're all about keeping your job, it's safer to buy what others buy. Don't believe me? Guess what American Funds' Growth Fund of America, the most widely held U.S. mutual fund, lists among its top holdings. How about Google (Nasdaq: GOOG  ) , Coca-Cola (NYSE: KO  ) , and JPMorgan Chase (NYSE: JPM  ) ? I know, surprise, surprise.

Of course, it's much the same for any "large-cap growth" fund your advisor will get you into. You don't need a certified financial planner to tell you that owning the same stocks as everybody else is no way to get ahead. Or that you can never expect to beat the market by owning the market. Right?

Here's proof ...
What I've just described is called "closet indexing." It's rampant on Wall Street, and investors pay billions in "management" fees each year for the favor. Yet of the 8,000 or so who invested money for U.S. investors in 2008, you can expect 78% to 95% to fail to beat the market, according to Yale University's David Swenson.

I knew it was bad, but 78% to 95%? That surprised even me. But I got that figure from John Bogle's new book, Enough, so I believe it. And at the risk of being labeled a Boglehead, I'll cite him again, because no one speaks more eloquently on the third and most important reason investors fail.

3. Getting killed by costs
I don't just mean the fund management fees we've discussed, but investment turnover, too. Not to mention capital gains taxes and trading commissions.

In his book, Bogle shows how, assuming market returns of 8.5% per year, you can expect these intermediation costs to eat up to 80% of your profits over the course of a 40-year investing career. Again, it sounds unlikely, but Bogle runs the numbers in the book; it's worth checking out.

But here's the point
Whether Bogle's 80% figure is high or low, we can agree: Coupled with the constraints placed on fund managers by the style box, and the understandable temptation to follow the herd, investors have a high hurdle to overcome -- especially if they rely on mutual funds.

Add to that a new, bear-market-inspired belief among certain financial advisors that they can -- and should -- help you time the market, and you can see why I say the stakes have never been higher. I mean, come on. You could argue that these market-timing converts might have come in handy in October 2007.

But we sure didn't need them "rotating" us out of stocks at the bottom, even though it meant racking up transaction costs and missing out on the ensuing huge rally. Of course, that's exactly what happened to many U.S. investors this year. Some may stay out of stocks for years -- and that's a crime.

Now your solution ...
Listen: None of this is rocket science. Neither is my solution -- namely, that you start managing some of your own investments and thus avoid the three reasons investors fail. If you're a purist like John Bogle, buy a low-cost index fund and be done with it.

Bogle doesn't believe we can beat the market with individual stocks. But I think we can. In fact, I've seen it. Motley Fool co-founders David and Tom Gardner have been recommending stocks of all shapes and sizes in Motley Fool Stock Advisor for seven years now, with remarkable results.

Since they started in March 2002, their recommendations have outperformed the S&P 500 by more than 10% on an annualized basis -- while the market has been dead flat. I have some ideas, but I'd be a liar if I told you I knew exactly how they do it. But I have seen it with my own eyes.

If you're ready to break free
It certainly helps that David and Tom Gardner are two very different investors with distinct styles, even if they are brothers. Short of finding another Peter Lynch, they may offer your best bet to break from the style box that hems in most professional investors and steer clear of the herd mentality on Wall Street.

And even if Bogle's right and you can't beat the market picking stocks, you can avoid the third, most deadly threat to your long-term wealth: crippling financial intermediation costs. Especially now that you can get David and Tom Gardner's top stock picks for 30 days absolutely free.

And if, like most investors, you do decide stay on, it won't set you back 80% of your rightful profits. Most importantly, you'll get the advice and support you need to stay invested, even when those who should know better cut and run. To learn more about this special free trial offer to Motley Fool Stock Advisor, click here.

Fool writer Paul Elliott doesn't own any companies mentioned. Intel and Coca-Cola are Motley Fool Inside Value recommendations. Google is a Rule Breakers recommendation. Procter & Gamble and Coca-Cola are Income Investor choices. Motley Fool Options has recommended buying calls on Intel. You can see the entire Motley Fool Stock Advisor scorecard with your free trial. The Motley Fool owns shares of Procter & Gamble and has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 18, 2009, at 11:41 AM, desertjedi wrote:

    Excellent article Paul. I came to similar conclusions a little while ago and transferred all my mutual fund IRAs to an online brokerage account.

    I do subscribe to Advisor and MDP for individual picks and another newsletter for more macro- and currency-related views.

    For better or worse, I have taken control of my financial future and have learned more about investing in the last year than the 48 years before that.

    Some people will never "liberate" themselves from the mutual fund scene and all the weaknesses you described. If that is the case, I would tell them simply to buy domestic and international index funds and simply stay invested at all times. It might be a recipe for mediocrity but it might fit best in their "comfort zone".

  • Report this Comment On December 18, 2009, at 11:56 AM, desertjedi wrote:

    Excellent article Paul. I came to some of the same conclusions recently and transferred all my IRAs to an online brokerage account.

    For better or worse, I felt that I could not let my life savings flounder in mutual funds. From the act of taking control of my financial future, I have learned more about investing in this last year than the 48 ones before that.

    I subscribe to Stock Advisor and MDP for my picks and another newsletter for macro- and currency-related views.

    If someone can't "liberate" themselves from mutual funds, I recommend they select of variety of domestic and international index funds and simply stay invested at all times.

  • Report this Comment On December 22, 2009, at 7:35 PM, footchester wrote:

    Unfortunately, except for the top tier of wealthy investors, the vast majority of individuals have 80 to 90% of their investment holdings in their retirement plans. I have one of the better plans offered by a large corporation and I can only invest at MOST 25% of my holdings in individual stocks; the rest must be in cash, mutual funds, bond funds or a money market account. Most USA retirement plans do not even allow for the 25% in individual stocks; an employees choices are funds, funds or funds. For those who leave their jobs every few years, they can rollover their 401k into an IRA and do what they want. But anyone who has a job they want to keep, the majority of their holdings are stuck in a 401k and their options are extremely limited. All of this talk of leaving funds for individual stocks is lots of fun, but just not possible for most people. Even at my large corporation, only a small number of people are even aware of the option to move 25% of their money out of funds; companies don't want to listen to sad stories from employees who lost their retirement fund on some penny stock. So they limit the amount that can be 'risked' to 25% or less, and do very little to publicize the individual stock alternative. If TMF wanted to do something useful, they would help employees convince their corporate overlords to loosen the restrictions on 401k rules. (not federal rules, company rules).

  • Report this Comment On February 18, 2010, at 1:08 PM, darryl1 wrote:

    Unfortunately John , most 401k plans that I know of

    don't allow individual stock picking other than the

    companies own stock. I am currently invested in three mutual funds that have done quite well.

    ARTVX 1 yr return 50% 5 yr 6%

    PTRAX 1 yr return 15% 5 yr 7%

    MIEIX 1 yr return 42% 5 yr 7%

    Those numbers are taken from Yahoo finance and tend to contradict John Bogel ( who's that? ), who's

    fiction is intended to guess what ,sell books.

    With respect to your defense of buy and hold . How

    does the correspond with the apocalyptic email I got

    with your signature on it predicting the impending

    doom of the stock market.

    One last comment , your newsletter ad stated it was

    60% off . I work retail and you can't take 60% off

    anything of value and still expect to make a profit.

    Even Intel doesn't have 60% profit margin . Maybe

    the regular price of your newsletter is too high?

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