The Top 1%

How would you like to be in the top 1%? You might be surprised how easy it can be to attain this elite 1% status.

No, I’m not talking about people with the highest income or net worth – those individuals who currently are the target of the Occupy Wall Street movement. If you’re not already there, I can’t get you into that group. However, I can tell you how to become one of the top 1% of the most effective investors.

To be among the best investors, it does not mean that you have accumulated the largest portfolio. Investors with all different size portfolios should strive to do the best they can with what they have. The goal of each investor should be to achieve the highest rate of return for the level of risk you are willing and able to take.

That said, the solution is surprisingly simple: just employ a low-cost market-matching investment strategy using index funds and exchange-traded funds. It’s very well documented that index funds and ETFs perform better than actively managed funds in every category. This disparity widens with the longer the time period covered. This fact is not in dispute except by those with a financial interest in promoting actively managed investments. In my article The Myth of Active Management, I explain this phenomenon.

A recent white paper published by the Vanguard Group shows that just 15% of actively managed U. S. equity funds beat the market over a 15-year period. As is usually the case for most studies of this type, the actively managed funds represented in the data are only the funds in existence for the entire time. That is, funds with especially bad performance that go out of business are not reflected in the results. This is known as “survivorship bias” and essentially means that the index funds would look even better if they were compared to all active funds.

Bond funds were not included in this particular study. Including bond funds would have made the active funds look even worse in comparison to bond index funds – because it is very rare for a managed bond fund to beat a bond index fund in the same category. No matter how you cut it, though, only a small number of active funds will out-perform a low-cost index fund in the same category over the long-term.

Intuitively, I’ve felt for quite some time that if the odds are so low of selecting one actively managed fund that will beat the corresponding index fund then is must really be difficult to choose several funds that will beat the market as a group. Investors need a number of asset classes in a portfolio to be properly diversified, such as international stocks, real estate and bonds. In his most recent book The Power of Passive Investing (Wiley 2010), Mr. Rick Ferri confirmed my suspicions by asking the logical, but rarely asked question: “How would a portfolio of actively managed funds have compared to a portfolio of all index funds?”

Based on Ferri’s analysis, he shows the results of a three, five, and ten-fund portfolio over different time periods. The results get progressively better for index funds (and progressively worse for actively managed funds), as more funds are added to a portfolio, and as the years are extended. A portfolio comprised of ten index funds of different types over twenty years is likely to beat a ten-fund portfolio of active funds 99% of the time. Thus, by taking this investment approach you have a very good chance of putting yourself amongst the top 1% of all investors!

Trying to select an active mutual fund to beat the market has long-been shown to be a waste of time and money. On the other hand, selecting an index fund requires very little investment knowledge yet can produce outstanding results. Taking it a step further, its easy to purchase an index fund for each asset class that you want represented in your portfolio. This means that achieving a top 1% performance is within the grasp of any investor. This top 1% of investors’ strategy might not make you as rich as the other top 1%, but it sure beats the alternative - and offers a sure-fire path to investment success.