Today I read an article by William Sharpe, titled “The Arithmetic of Active Management” [1]. It presents an intuitive concept that for some reason is frequently overlooked: The average invested dollar must equal the market return.

Then, after fees and commissions, the average invested dollar must underperform the market. That’s why the majority of mutual funds do worse than a random portfolio of stocks.

Tools such as derivatives and short-selling add overhead cost and also, on average, don’t beat the market. While you think you are hedging your investments by buying options contracts, another investor is thinking the same thing when he sells you those contracts.

So, unless you have compelling stock information that others don’t have, active trading will rarely help you beat the market. Mutual funds will rarely help you beat the market. Diversification, long-term investing, and choosing companies with strong fundamentals, are what beat the market.

The market has fallen over 50% since October 2007, so if you still have more than half your portfolio value from back then, Congratulations – you beat the market.

1. The Financial Analysts’ Journal Vol. 47, No. 1, January/February 1991. pp. 7-9

William Sharpe was awarded the 1990 Nobel Prize Laureate in Economics. I don’t think this is what he won it for, though.

From The Motley Fool:

Men trade 45% more women, and earn a net annual return of 1.4% less. Ha ha ha.

The authors cite increased trading costs, taxes, and a greater tendency to speculate as reasons for this underperformance.

http://www.fool.com/investing/general/2009/03/07/attention-single-men-stop-trading-so-much.aspx

There are a lot of rules out there regarding how much to invest in stocks vs. bonds. Every single one of these rules was pooped out by some financial adviser with no quantitative reasoning.

One common one: The percentage of your investments that should be in stocks is equal to 100 minus your age.

Advice from Kiplinger: “If you’re investing for retirement, keep 90% or more in stocks until you’re within six years or so of retirement.”

I don’t like hard-and-fast percentages, so here’s the rule I’ve been using my whole life: When investing in anything, invest just enough to make you nervous. It can apply to your whole stock portfolio, individual assets, or the cash you stow under your mattress. If you’re going to put money anywhere, put enough in there to make yourself nervous. Otherwise you won’t bother to keep track of it.

These days, treasury bonds make me nervous because the government is flooding the market with supply to fund their expensive stimulus programs and bailouts.