You’re probably not a very good investor.

Don’t take my word for it.  Sam Ro wrote this stunning blog post on Business Insider.  You tend to panic when markets drop, which causes you to miss out on the relatively few days when the market posts stellar returns.  You buy high and sell low, based on an analysis of mutual fund flows.

Because of this conduct (and others), an analysis of returns for the 20-year period from December 31, 1993-December 31, 2013 found the annualized returns of the “average investor” hovered around 2% for that period, which didn’t even keep up with the pace of inflation.

Part of the problem is the kind of investment products you purchase.  Here’s my personal list of investments ranked from worst to best.  Where are you on this hierarchy?

Six Investments Ranked Worst to Best

Hedge funds: Someone once told me hedge funds are for “stupid, rich people.”  I agree.  High fees combined with low returns give this investment its top position on the list.

Private Equity: Similar to hedge funds, private equity also has the allure of exclusivity.  Investors sacrifice liquidity and transparency.  These investments are difficult to evaluate and there’s sparse evidence private equity investments generate higher returns than risk-adjusted benchmarks.

Individual stocks: It’s not impossible to pick a stock “winner”, but your chances of doing so are statistically exceedingly low. As I stated in this blog post:  Owning individual stocks, rather than diversifying through ownership of an index fund made up of similar stocks, significantly increases your risk without increasing your expected return. Think about well-known companies that once were "sure things," but are no longer around, such as Lehman Brothers, Enron and Bear Stearns.

Actively managed mutual funds: If you want to pay high fees, with the likelihood of underperforming a comparable, low-management fee index fund, buy an actively managed mutual fund. Most investors do, and their returns suffer as a consequence.  There’s a mountain of data indicating the folly of buying these funds, but they are aggressively sold and many investors don’t know the data.  Don’t be one of them.

Index funds: Low-management fee index funds, in a suitable asset allocation (the division of your portfolio between stocks, bonds, and cash), are an excellent choice for investors.  Vanguard is the gold standard for low fee index funds, but there are a number of low-cost exchange-traded funds and index funds available from other providers (like i-Shares, Fidelity and Charles Schwab) as well.

Passively managed funds: I set forth the differences between passively managed funds and index funds in this blog.  These differences can yield significantly higher returns to passive fund investors.  A leader in passively managed funds is Dimensional Fund Advisors.  Dimensional funds are available only through authorized advisors.  You can find an authorized Dimensional fund advisor here.

Resource of the week

My blog post on US News discusses the good, the bad and the ugly of investments in more detail.

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