Tips for Taking the Right Vehicles to the Stock Market

PHOTO: Stock picking can be as dangerous as a crowded highway. Here are some alternatives.

One of the most common reasons investors fail is that they approach the capital markets without a plan that calls for the right investment vehicles for their needs. Or, if they have a plan, it may not adequately manage risk according to their individual tolerance for it.

Getting a good grip on risk and ways to reduce it is essential for women seeking to become financially empowered. Remember: The “e” in empower stands for “education,” and education about risk is critical.

Even if you have a well-thought-out asset allocation plan – one that sets what percentage of your money to invest in one asset class (eg., stocks) versus another (eg., bonds) – you may still face considerable risk from choosing the wrong vehicles to access different asset classes. This can mean too much risk, high costs or both.

When investing in stocks, there are substantial risks from buying ill-fated companies. Choosing companies that are likely to do well is an extremely complex undertaking that few professionals can master. The reason for this is what's known as company risk (or idiosyncratic) risk. Unbeknownst to its investors, a company can be awash in this type of risk. The CEO could become depressed, new board members could be ignorant cronies rather than savvy corporate stewards, an expected regulatory approval could be about to fall through or the company could be preparing to release a defective new product.

But what if you purchase a wide variety of stocks to spread company risk around? That's what professional portfolio managers do. They know that they'll unavoidably pick many losers, so their goal is to pick more winners. Yet this is extremely difficult to accomplish. It involves vexing choices about which industries to invest in and how much in each industry and each company. As I tell my clients, don't try this at home.

Good alternatives to stock picking include mutual funds or exchange-traded funds (ETFs) The objective is to reduce exposure to company risk by increasing the number of companies you invest in and decreasing the percentage of your portfolio invested in any one company. Instead putting too many eggs in one basket, you need many baskets.

There are two basic types of mutual funds—actively managed and passively managed. In actively managed mutual funds (typically known simply as mutual funds), investors pay fees that collectively comprise the high compensation of professional portfolio managers who buy and sell stocks for the fund. In index funds, there is almost no active management because the fund's performance is pegged to that of a set group, or index, of stocks – for example, the Standard & Poor's 500. This significantly reduces costs to shareholders, compared with those of actively managed funds.

ETFs function like an index funds, with some key advantages. One is that, because they're traded on an exchange, you don't have to wait until the end of the day to sell or buy, as you do with actively managed mutual funds.

If you invest in actively managed funds, you should get a significant return that compensates you for their higher costs. But the unfortunate truth is that most active managers don't earn their high compensation because the returns that most of them produce over those of index funds (known as their benchmark) fall short after expenses – and often, before expenses.

You should always focus on net returns. Even if you own a fund that has great absolute returns, this does you little good if you have to pay too much for them.

Before or after expenses, the issue of whether fund managers can outperform the market is part of a longstanding debate in the investment community over which is superior – passive management (indexing) or active management (buying and selling stocks in a portfolio, as mutual fund managers do).

This debate, with intensity and vitriol comparable to differences between political parties, has persisted for the 40 years that index funds have existed, and shows no signs of abating.

Indexers embrace the findings of economist Eugene Fama (winner of the Nobel Prize for economics this year) that markets are "efficient" – meaning that prices tend to reflect information that everyone in the market already has. Indexers have interpreted Fama's findings to mean that, because all known information is already priced into a stock, there are no bargain prices. The upshot of this, indexers argue, is that it's impossible to consistently identify winners and thus outperform the market.

While acknowledging the concept of market efficiency, active-management proponents argue that windows of inefficiency – instances where stocks are temporarily underpriced because it might take a while for new information to become widely known – create opportunities for adroit active managers.

If this is the case, precious few active managers are adroit and, if they are, they don't stay that way for long. Those who consistently beat their benchmarks tend to lose steam after a few years.

Picking winners is extremely difficult, but there are other reasons these managers' funds eventually founder. One is that, after acquiring a lot of investors and assuring a good income for their fund companies and themselves, managers have a tendency to become closet indexers to protect against losses that may cause investors to cash out. This more conservative approach tends to preclude the kind of high-flying returns the fund was achieving when the fund company began touting it.

And the company began touting the fund because it was doing well initially, when the manager was taking more risks but succeeding. Had such managers not succeeded early on, most investors would never have heard of these funds. So, while it looks like managers almost always tend to lose their mojo, it's because it's almost planned that way; it's a stage in the cycle of every successful (for a time) mutual fund.

A mutual fund manager's record doesn't help you if you're investing in that fund today. Too many investors chase past performance to their peril.

How can you identify mutual fund managers who are likely to do well in the next couple of years? This is an extremely difficult task that requires extensive knowledge and advanced technical tools.

Whatever tools you use to access the capital markets, there will be risks. One of the greatest types of risks you face are those you pose to yourself. Women might have an edge in this regard because in investing, pride definitely goeth before a fall. Research shows that prideful overconfidence among men leads them to mistakes from investing too aggressively – without as much regard for risk – as women have. So an investing mantra for women investors might be: Don't listen to your husband or boyfriend.

This isn't to say that women can't invest themselves broke just as easily as men; they just do it differently.

One way that women and men can protect themselves is to get a qualified advisor who can bring clarity, market knowledge and, above all, discipline.

Whether you do hire and advisor or go it alone, you must consider risk for every decision. Generally, all investors must decide: Do I want to take high risk for potentially high returns or would I be more comfortable with lower likely returns and lower risk?

Unless you're an extremely advanced, experience investor, the best way to do that when investing in stocks is to forgo active portfolio management – especially your own – in favor of index funds and/or ETFs.

When you use active management the reduction of your net returns from high costs isn't a risk; it's a certainty.

This work is the opinion of the author and not that of ABC News.

Laura Mattia is a partner with Baron Financial Group, and a fee-only financial advisor. She's a Certified Financial Planner professional (CFP®), a Chartered Retirement Plan Specialist (CRPS®) and a Certified Divorce Planner (CDFA™) and holds an M.B.A. in accounting/finance. Her Internet radio show is Financially Empowering Women™ with Laura Mattia. A professor at the Rutgers University Business School, Mattia is completing a Ph.D. in financial planning from Texas Tech University; her dissertation is on how to help women plan for retirement.

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