Mutual Funds: The Confidence Game Understanding mutual funds and why they are a dangerous game to play. BY AL JACOBS
Much of the fluctuation on the stock market is based on confidence. Living financially on the edge doesn't help that confidence.
Perhaps the most famous newspaper headline of all time appeared in the New York City Variety on October 30, 1929, the day following the massive sell-off in the stock market known as Black Tuesday. It read: "Wall Street Lays An Egg." A period of economic malaise followed, culminating in a worldwide depression lasting throughout the 1930s that strained the very fabric of society. That financial cataclysm shattered the confidence of a full generation of Americans in stock investment. Many never returned.
The investment industry recovered slowly. In the decades that followed, it worked mightily to convey to its active and prospective clients that sums entrusted to it resided in good hands. The open-end investment company, known as the "mutual fund," which originated in 1924, was promoted to offer diversification. Marketing concepts such as dollar cost averaging and asset allocation were established and continually refined to connote fundamental reliability. Above all, the brokerage firms, whose profitability depended upon a continual influx of money from the general public, spared no effort in conveying a sound institutional image. Goodwill became a most valued commodity.
Rules of the Game
Somewhere along the way, a doctrine known as "investor confidence" developed. Though initially an arcane concept used by professionals to explain manifestations in the economy, it rapidly developed a life of its own. The realization that the psychological impact of investor attitudes could, in fact, move markets appealed to those forces that controlled and profited from such movements. Banks, brokerage firms, investment houses and government agencies soon established and embraced various guiding principles in this new science. With the adoption of a prescribed dogma, investor confidence truly came of age. Terms such as "adaptive expectations," "integrity of research," "regulatory oversight" and "empowerment of investors" became imbedded in the prescribed lexicon.
Of course, no scienceóor pseudoscienceócan thrive without an established set of numerical references. Mere assertion of rising investor confidence over a prescribed period of time is of limited value. It is far more credible if you can say, "Authoritative sources confirm that investor confidence increased by 37 percent over the past 12 months." Accordingly, the interested parties devised methods to measure and report on investor confidence. The benchmark they established was called the Investor Confidence Index. Iíd like to enlighten you by describing exactly how it works, of course, but itís not as simple as that.
Playing the Game
As the late comedian Jimmy Durante said, "Everybody wants to get into the act." Any device with a variety of potential uses will be grasped by many hands. And once out of the hat, this rabbit did what rabbits are known to doóthe indexes proliferated. Thus, as with any apparatus, you may choose the index that best suits your needs. If the Rasmussen Consumer Index does not give you the economic confidence trend that pleases you, perhaps the WILink Investor Confidence Index will be more to your liking. Similarly, if the Yale School of Management Stock Market Confidence Index fails to indicate sufficient market resilience to impress a client, then take a look at the AITC Investor Confidence Index. And finally, does the Rating Research Investor Confidence Index disclose a valuation confidence that dismays you? Have no fearóyou may get a more preferable number from Forumís Investment Confidence Index. Iíll not go on, as I think you get my point.
Letís now take a brief look at our current economic conditions as 2008 departs. Understand that America is not alone in these troubled times. It is an international phenomenon, with pessimism evident as investors all around the world flock to the relative safety of U.S. 30-year Treasury bonds, which are considered a haven in times of uncertainty. During the month, global stock market values tumbled by trillions of dollars, while decimation of pension funds and individual retirement accounts dictate that many an aspiring retiree will continue working for the unforeseeable future. Perhaps most depressing of all is that government and financial leaders, to whom the populace looks for leadership, are equally clueless as to a remedy for the troubles. It appears that confidence occupies a dispirited level not seen since the Great Depression.
The Panic of 2008
Itís in this milieu we experience "The Panic of 2008," as it will eventually come to be known. If there is a single mantra to describe the securities market, in which most Americans house their worldly assets itís, "Stocks plunge on fears that stocks will plunge." This is because selection of individual stocks based upon soundness and potential profitability is not a criterion on which investments are made. Instead, the overwhelming fixation of investors and their advisors is on mutual funds, often dominated by index funds. In this way a typical portfolio contains a conglomeration of debris, chosen at random to satisfy some formula or contrived allocation, and understood by neither investor nor practitioner. Is it any wonder that confidence plummets in a prolonged market decline? As there is no fundamental basis on which to evaluate holdings, such as price/earnings ratio, dividend yield, or asset value, market fluctuations become little more than a roller coaster ride in which a personís net worth oscillates uncontrollably. This is no way run an investment program.
Confidence, based upon measurable performance, is sensible, and possible with carefully selected securities that meet objective standards. The same cannot be said for a typical mutual fund portfolio. Itís for this reason that my holdings over the years consisted of stocks and bonds specifically selected to meet the needs I chose, and never a mutual fund. For a more detailed view of my reasoning, you might care to visit www.onthemoneytrail.com, enter Newsletter Archives at the upper right hand corner of the homepage, and click onto January 2007, "Why I Donít Invest in Mutual Funds."
Al Jacobs has been a professional investor for nearly four decades. He is a nationally syndicated columnist and appears regularly on ProducersWeb.com, DrLaura.com and SheKnows.com. He draws on his extensive expertise in real estate, mortgage, and securities investments to counsel millions on how to invest wisely and spend prudently. He is the author of "Nobodyís Fool: A Skepticís Guide to Prosperity." Subscribe to his financial column, "On the Money Trail," at no cost or obligation, by visiting www.onthemoneytrail.com.