"The king has no clothes" is the best way to describe the army of investment professionals who flood our mailboxes with newsletter junk mail extolling their expertise as investment gurus.
For those of us curious about what these people have actually achieved, we can go to Mark Hulbert, who recently celebrated his 25th year ranking them.
For those in the investment business for 20 years or more, only 15 percent have beaten the market averages during that period. The percentage of winners is even less because the denominator fails to include all the gurus who went out of business during that time.
Meanwhile, a recent report from Boston College's Center for Retirement Research made the case that the average 401(k) investor earned 1 percent less than the average rate of return on the pooled money in traditional pension plans managed by professional money managers.
Looking at the period from 1998 to 2003, the study pointed out that the average pooled pension account earned an average of 6.6 percent per year while the average 401(k) account gained 5.6 percent. From 1988 to 2004, the pension plans with pooled assets earned 10.7 percent while 401(k)s earned 9.7 percent per year.
I would jump to the conclusion that the difference was probably attributable solely to the difference in investment fees. Large pension plans pay next to nothing for money management.
In 401(k) plans where mutual funds predominate, the hidden fees of annual expense ratios average slightly more than 1 percent. In some cases, charges to participants for the administration of the plan and sales commissions can bring the total annual cost to more than 2 percent. Because nobody ever writes a check for these expenses, people are routinely ignored while they eat into what could have been future retirement nest eggs.
Out of curiosity, I decided to see how a participant in one of our 401(k) plans would have fared if they had invested their money equally over an actual mix of funds that we have offered in a typical plan over the past three, five and 10 years.
We are a proponent of diversification and the Modern Portfolio Theory approach of selecting a diversified mix of fund types and rebalancing periodically. In this comparison, we are assuming that the amount of money in the funds remained constant without rebalancing, and we are using the following selection of stock-oriented funds that is an actual case.
The funds offered in the plan included Third Avenue Real Estate, American Funds World Stock, Vanguard Windsor II, JP Morgan Mid Cap, Royce Total Return, Van Kampen Comstock, Dodge and Cox Balanced, Baron Small Cap, Dreyfus Premium Alpha, Ariel, Vanguard 500 Index, North Track Tec 100, Eaton Vance World Health and American Century Ultra.
Their total average annual rate of return for the past three-year period was 12.7 percent. For the past five years, it was 7.6 percent. The S&P 500, by comparison, earned 10.8 percent and 2.8 percent for the equivalent periods. The returns for the total stock market (which this collection of funds better represents) were 11.9 percent and 4.25 percent, respectively. Ten-year equivalent numbers would have been 11.16 percent for the 401(k), 9.02 for the total stock market and 8.8 percent for the S&P 500 Index. The average annual expense ratio or cost for these funds was 0.9 percent -- a figure already factored into the reported returns. The point here is that a 401(k) plan with a selection of high-quality investment choices and low fees can allow the employee/participant to beat these national averages, a feat that only 15 percent of the money managers have been able to accomplish.
Going forward, with a brand new plan, it is easy to demonstrate that a new selection of funds will beat these averages by as much as 10 percent per year, but this is specious and based only on the advantage of hindsight. As John Bogle of Vanguard points out, there is no way to know prospectively who will outperform the market averages going forward. This is why I was careful to use an actual case whose investments were chosen in past years.
The Boston College study goes on to point out that the 1 percent of annual return difference cuts or increases the ultimate retirement nest egg by 20 percent. Earning a few percentage points in annual average gains (or achieving them by reducing hidden fees) brings the power of compound interest in to play out at the purest expression of the phenomenon -- the last few marginal percentage points that really make a difference.
Anyone who has used this simple approach has beaten markets, performed better than 85 percent of the experts and is hereby qualified to start writing their own investment newsletter.