Posted on Wednesday, December 1, 2010
Every day millions of shares of stocks and mutual funds are traded on the national exchanges. The system is premised on an equal playing field. Buyers and sellers are supposed to have access to the same information in order to make decisions about whether to buy or sell.
Many have long suspected this premise is false. We know the "big boys" have access to super computers which provide trading information nanoseconds before it's available to others, giving them the opportunity to use this data before it's known to the average investor. It's called "high frequency trading" but it's really nothing more than legalized front running.
According to an article in the Wall Street Journal, this is child's play compared to the inside trading that pervades the markets.
The article reports a three year investigation by federal authorities that could "ensnare consultants, investment bankers, hedge-fund and mutual-fund traders and analysts across the nation..."
Who is on the wrong side of these trades? The average Joe who is trying to save enough for retirement.
Even without this illegal activity, the securities industry practically insures most investors squander their money. The industry wants you to believe some "guru" (usually your friendly broker) has the skill to pick stocks or mutual funds that will beat market returns. A recent study by Standard and Poors demonstrates the confusion between luck and skill which is fostered by these "experts."
The study found that, over the five years ending September 2009, only 4.27% of large-cap funds, 3.98% mid-cap funds, and 9.13% small-cap funds were able to repeat their top-half or top quartile rankings.
No large- or mid-cap funds, and only one small-cap fund maintained a top quartile ranking over the same period. Over longer periods, persistence of performance generally was less than you would expect from random chance.
Other studies support the view that stellar performance by actively managed mutual funds can be attributed to luck and not skill.
The ramifications of the insider trading scandals and these studies are profound and largely ignored by retail investors. If mutual fund managers had skill, you would expect a high correlation between past returns and future returns. This correlation does not exist. Since they don't have skill, relying on them to produce outsized returns is gambling and not investing.
While that is depressing enough, add the fact that the entity on the other side of your trade may have inside information that gives them an unfair edge.
The conclusion is both inescapable but elusive for most investors: Your goal should be to capture market returns, using a globally diversified portfolio of low cost index funds, in an asset allocation appropriate for you. This means firing your market beating broker or advisor and selling all of your individual stocks, bonds and actively managed mutual funds.
You can be a victim or victor in your quest for financial security. You are looking for guidance in all the wrong places if you a relying on the securities industry to help you get there.
Dan Solin Huffington Post