Should I use an investment advisory service?

Reader's Question: Which is a better way to invest--subscribing to a portfolio advisory service or choosing mutual funds on my own?

I look at investing as consisting of three primary decisions:

Buy equities or fixed-income instruments?

Buy individual securities or a highly diversified portfolio?

Use advisors or do it yourself?

Favoring Equities

As I have mentioned in earlier blog entries, I strongly favor holding essentially 100% equities in an investment portfolio. Historically, equities have outperformed bonds, bank deposits and other fixed-income instruments over multi-decade time horizons. Surely, there have been instances, like the post-tech-bubble fallout during 2000-2002, when equities have shown sharply negative returns. However, over the long run, given our wealth-centric, industrial economy driven by political, govenmental and social forces all promoting growth, it is, in my opinion, highly unlikely that equities will underperform bonds and cash for significant time periods. The current softness in the real estate sector may dampen consumer spending and lead to a recession, but I believe that our economy is quite resilient (though always "on the brink," as George Soros puts it) and will in due course provide better returns for businesses, owners of capital and risk-takers than for those who choose the "safer," fixed-income alternative.

Concentrated Portfolio

Owning one stock or mutual fund is not diversified enough and owning more than a few dozen stocks or mutual funds can be cumbersome to manage. I prefer to hold somewhere between 10 and 20 positions in my portfolio. In practice, I have found that if I hold more than this number of positions, I become unable to track closely enough the news and relevant events affecting my securities. Also, with fewer than about 10 positions, it becomes more difficult to tell if portfolio success (or failure) is just good (or bad) luck or actually statistically significant. For those who prefer mutual funds, it is possible to achieve adequate diversification with just a few fund selections, since the funds themselves are usually quite diversified. For reasons I provide below, however, I prefer managing my own concentrated portfolio of individual securities over investing in more highly diversified, fee-taking mutual funds.

Investing On Your Own

The price behavior of stocks is driven by a combination of random and non-random elements, with the predictable (i.e., non-random) factors typically being so weak that management fees, trading commissions, bid-offer spreads and other frictional costs tend to "wash away" the advantage that any sliver of predictability offers. Hence, we often hear how mutual fund and, more recently, hedge fund managers generally underperform market averages, despite their education, experience, talent and high incentive pay. Compared to practitioners of other professions (e.g., medicine, law and accounting), which offer services exhibiting more predictable outcomes and demonstrable benefits for clients, portfolio managers unfortunately find themselves battling market forces beyond their control. Given the intrinsic unpredictability of the financial markets (at least in the short run), it makes little sense to hire "expert" advisors who have no better than a random chance of outperforming the markets, especially after taking into account the management fees they charge.

Subscribing to a stock-picking or investment-timing advisory service will typically leave you no better off than handing over your investable assets to mutual fund managers. Instead, what I would suggest is one of two alternatives: either do your own research and pick your own equities, or invest in exchange-traded funds (ETFs) that replicate the performance of a market index or sector without making an attempt to time the market. The one area of investing that you do have control over is your out-of-pocket advisory fees and expenses, and keeping these at a minimum will likely improve your investment returns in the long run.