I often receive emails from investors expressing a mixture of confusion and panic. That confusion can come in several forms:

• “My portfolio isn’t doing nearly as well as I’d hoped. What am I doing wrong?”
• “I just started to learn about investing, and I’m lost! Help!”
• “I read previously that I should invest by doing X, but now I’m reading that I should be doing Y instead. Who should I believe? What should I do?”

Step 1: Do Nothing.

I’ve written before about my version of the 30-day rule:

Every time you’re tempted to adjust your portfolio in some way, don’t. Instead, write down your idea, your reasoning behind it, and the date. 30 days later, if the reasoning still makes sense, then (perhaps) give it a go.

I still think that’s a good idea. Even if you’re in a truly dire situation, making major investment decisions a) while you’re panicked or b) before you’ve fully researched all your options is unlikely to work out well.

Step 2: Consider Both Sides.

One of the reasons investors get so confused is that the people giving investment advice all seem to disagree with each other.

For example, my friend Neal is a CFP with more than 20 years of experience, and I have no doubt that he intends the very best for his clients. Yet he and I disagree adamantly on some investment topics:

• I think index funds and ETFs are hands-down the best way to own stocks. Neal isn’t convinced.
• I think single premium immediate annuities are a helpful tool for retirement planning. Neal thinks they’re primarily designed to enrich insurance companies.

So here’s a person with credentials, experience, and ethics recommending a very different approach to investing than what I’d recommend.

If we then consider the fact that there are many people/parties in the investment services industry who don’t have your best interests in mind, it’s no surprise that you see conflicting advice everywhere you turn.

But that doesn’t have to be a problem. If you take your time and research both sides of an issue, you’ll be able to decide for yourself who presents a more compelling argument. For example:

• Can’t decide whether picking stocks is a good idea? Read How to Make Money in Stocks, then read The Investor’s Manifesto.
• Can’t decide whether you want a stock-heavy allocation or a bond-heavy one? Read Stocks for the Long Run, then read Worry-Free Investing.
• Can’t decide about active funds vs. index funds? Read Fund Spy and The Little Book of Common Sense Investing.

I’m a big advocate for keeping things simple.  In my opinion, it’s essential that your investment strategy be simple enough that you can:

1. Understand it, and
2. Implement it properly.

If you don’t have a rock-solid understanding of your investments and investment strategy, your exposure to both scams and costly mistakes goes up dramatically.

That said, simplicity sometimes comes with a cost. In such cases, you have to ask: Can I afford it?

Simplicity and Target Retirement Funds

Target retirement funds are the simplest way to put together a diversified portfolio. But they come at a cost.

At many fund companies, the target date fund includes a level of costs in addition to the costs of the underlying funds that it owns. In other words, you’re explicitly sacrificing returns in order to have the fund manager rebalance between the funds for you.

And even at those companies that don’t charge an additional layer of expenses for their target funds (Vanguard, for instance), you take on an additional level of risk by using a target date fund. Specifically, you take on the risk that the fund manager will change the “glide path” without you realizing it. If you don’t pay attention, your portfolio could end up with a very different asset allocation than you’re expecting.

Is it worth taking on risk (and, depending on the company, additional costs) in order to have a simpler portfolio?

Simplicity and Diversification

Outside of target date funds, the simplest index fund/ETF portfolio I can imagine would be something along these lines:

• A total U.S. stock market index fund,
• A broadly diversified international stock index fund, and
• A total bond market index fund.

In terms of number of securities, it’s hard to be more diversified than that. But many people (myself included) would argue that you could improve your diversification by adding some or all of the following to your portfolio:

• A REIT fund,
• A TIPS fund, and
• Small-cap and/or value funds.

Of course, by doing so, you’ve taken the number of funds in your portfolio up from three to six or more. Although, as Larry Swedroe has argued in defense of his 11-fund lazy portfolio, if you’re only rebalancing once per year, adding more funds doesn’t increase the workload by that much.

In this case, I’d vote for better diversification rather than a simpler portfolio.

Simplicity and Annuities

I’ve been writing a lot about single premium immediate annuities lately. In part, it’s because I think they’re an extremely useful tool for retirement planning. But it’s also because I suspect that one of the reasons many people stay away from annuities is that they just don’t understand them.

And that makes sense. Not understanding an investment is a good reason to refrain from buying it. It’s not, however, a good reason to refrain from learning more about it.

What’s the value of simplicity?

All else being equal, I’ll vote for the simpler option every time. But the more I learn about investing, the more I realize that simplicity often (though certainly not always) comes with a cost–whether lower returns or higher risk. And I find that the price I’m willing to pay solely in exchange for simplicity is actually rather low.

Everybody in the personal finance industry (myself included) has a business interest in getting you to believe one thing or another.

• Mutual fund companies have a vested interest in convincing you that mutual funds in general (and their funds specifically) can beat the market.
• Discount brokerage firms have an interest in convincing you that it’s profitable to pick stocks and trade them frequently.
• Major financial magazines receive their advertising revenue from fund companies and brokerage firms, so they need to cater to the interests of those two groups.

So who can we turn to for unbiased information?

Professors and Academics

In contrast to the parties mentioned above, the academic community’s primary interest is simply in making new, verifiable findings and getting them published in reputable trade journals.

This is terrific. It makes them (mostly) unbiased.

The flip side: They have little to gain from making their work accessible to the public. So, for the most part, they don’t. Their work is intended to be read by people who know the meaning of terms like kurtosis, autocorrelation, and mean-variance analysis.

This is almost the precise opposite of the financial services industry, which is all too happy to spread easy-to-understand, profit-generating, though factually dubious ideas. (“Index funds only earn average returns. You’re not just average, are you?”)

Evaluating Information

If you’re the type who doesn’t mind technical jargon, I’d suggest spending some time on the Social Science Resource Network. You’ll find studies there on everything from the performance of investment newsletters, to persistence of mutual fund performance, to sorting out luck vs. skill in mutual fund returns.

If, however, you don’t particularly relish the idea of reading academic papers, I suggest the following plan of action:

1. Assume that the primary goal of everybody in the financial services industry is to take your money. (Yes, that includes the financial advisor you know from Church as well as the one who coaches your daughter’s softball team.)
2. Determine how that goal influences the information they’re providing you.

Is it bordering on paranoid? Yes. Will it be untrue in many cases? Of course. But it’s a heck of a lot closer to reality than, “Assume that everybody has your best interests in mind.”

That’s all CNBC, The Motley Fool, and all the get-rich-quick blogs, newsletters, and books are doing. Nobody wants to be told that successful investing usually requires decades of:

• living below your means,
• investing regularly,
• removing any and all excitement from your portfolio, and
• sticking it out through scary markets.

We’d rather hear that there’s a way to:

• become wealthy in a hurry,
• with minimal effort, little risk, and a small initial investment,
• while proving that we’re smarter than everyone else.

It’s not terribly surprising that there’s a whole industry built upon selling us the message we want to hear.

Administrative note: There will be no new post tomorrow–taking the day off for Thanksgiving. And on that note, thanks to each of you for the roles you play here (whether buying one of my books, sharing the blog with others, or participating in the discussion). Being able to do this full-time is literally a dream come true for me. So, thanks.

There appears to be a prevailing sentiment that diversification failed in 2008 because U.S. stocks, international stocks, and REITs all went down at the same time.

The thing is, that’s what usually happens when one of them goes down. They are, after all, positively correlated.

In fact, even bonds–the asset class most frequently used as a diversifier for an otherwise stock portfolio–have a historically positive correlation with the U.S. stock market. If stocks go down in a given year, more likely that not, bonds went down also.

Does this mean bonds are ineffective as a diversifier? Of course not. They’re a helpful diversifier because their correlation to U.S. stocks, while positive, is quite low.

Math Refresher: Correlation Coefficient

In case it’s been a while since you studied correlations, here’s a refresher:

• If two variables have a correlation coefficient of 1, they move in perfect lockstep. One goes up, so does the other.
• If two variables have a correlation coefficient of 0, they’re completely independent. The movement of one has no value for predicting the movement of the other.
• If two variables have a correlation coefficient of -1, they’re perfectly negatively correlated. When one goes up, the other goes down.

Negative Correlations: Dream On.

The dream asset class is one that would have a long-term expected return similar to stocks as well as a negative correlation to stocks (such that when one has a bad year, the other usually has a good year).

However, it’s rare that you’ll find asset classes with negative correlation to the stock market (aside from asset classes with negative expected returns). In fact, even looking for a zero correlation is quite difficult. In most cases, a low positive correlation is all we can hope for.

Seeking Low Correlations

You benefit any time you add an asset class to your portfolio that has:

• A correlation (to the rest of your portfolio) of less than 1, and
• A similar expected return to the rest of your portfolio.

That’s why international stocks make a worthwhile diversifier to U.S. stocks even though their correlation is quite high. When one has a bad year, there’s at least a chance that the other had a good year. Or, more likely, when one has a truly terrible year, the other may only have a “sorta bad” year.

And with bonds, even if they lose money in 2/3 years in which stocks lose money, they still provide a diversification benefit because:

• In the other 1/3 bad years, they must have gone up, and
• Even in the 2/3  bad years in which bonds also went down, they likely went down less than stocks.

In other words, all we’re looking for when we diversify is asset classes that will behave differently from stocks (without sacrificing too much expected return), not asset classes that always go up when stocks go down.

So did diversification fail us?

Just because U.S. stocks, international stocks, and REITs all went down in 2008 doesn’t mean “diversification failed us.” They did, in fact, all perform differently from each other–exactly what we’d hope they would do. And bonds had a great year, with many bond funds putting up double-digit returns.

It seems to me that diversification didn’t fail at all. It worked perfectly according to plan–practically a banner year for the “here’s why you should diversify” message. So what failed? The general public’s expectations and understanding of diversification.

Year after year, decade after decade, the actively managed fund industry fails to deliver on its promises. Yet year after year, decade after decade, investors hand their money over to actively managed fund companies in the hopes that they’ll earn above-market returns.

Why is this? As far as I can tell, it has to do with:

1. The structure of the industry, and
2. How enticing and at-first-glance-believable the industry’s promises are.

Why Settle for Average?

“Wall Street cozies up to you and whispers in your ear, ‘You can do better than that…Why settle for average?’” — Bill Schultheis in The New Coffeehouse Investor

It’s such an alluring message. We don’t like being average.

And every broker (or large fund company) has data to show that they can beat the market. It’s plain as day. They’ve done it before. “Look here. See these five funds? Each of them beat the market. In fact, they each beat the market by more than 3% per year.”

Who wouldn’t invest in that? It’s a slam-dunk sales pitch when dealing with most investors.

The problems, of course, are that:

• We’re never shown the thousands of funds that underperformed. (As Schultheis would say, the fund companies are “hiding their bad report cards.”)
• It’s as good as impossible for the average investor to determine ahead of time which funds will outperform.

As Kenneth French (a big-name professor in the finance community) put it in this video interview:

“Stock returns are incredibly noisy. So if I’m out there trying to hire a great active manager who can pick winning stocks, looking at their track record, it’s going to be very hard for me to decide they performed so well because of skill [or] they performed so well because of luck.”

A Stock Picker’s Market

The other most common lie from the active fund industry is that “this is a stock picker’s market.” This lie comes in one of two forms:

• “In a roaring bull markets like this, expert management can really show its value.”
• “Our expert management will protect you in a down market.”

At first glance, either one of them seems to make sense. However, the fact that they argue that active management is especially good in both up and down markets is a clue as to the lack of truth behind the assertion.

And as William Sharpe famously pointed out, the arithmetic of active management must hold true at all times, over all periods. Kenneth French puts it this way:

“This is not a statement that over the long-haul, I expect on average to win. It’s not every five years. It’s not every three years. It’s not even every month, or every day, or every second. It’s every instant. Every instant, I know that the return on my passive market portfolio is going to be higher than the value-weighted average of everybody else.”

Once it’s framed in those terms, index investing sounds pretty enticing itself, doesn’t it?