Understand Your First Law of Investing

Physician's Money Digest, November 2005, Volume 12, Issue 15

Overwhelming evidenceproves that earningextraordinary investmentreturns (ie, muchhigher than marketaverages) over the long term is nearlyimpossible because financial marketsare highly competitive; opportunitiesto earn extraordinary returns rarelycome up; and it takes exceptional talentto take advantage of such opportunities.Yet time and again, millions ofinvestors fall for the claim that theirmoney manager or analyst can generateextraordinary returns even afterexorbitant fees and costs. Let me illustratethis contradiction with the followingexamples.

Weed Out Hedge Funds

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Even professional investors havepoured money into hedge funds forsome time now based on little morethan faith and out of desperation dueto low interest rates and poor stockmarket performance. Most hedgefunds will never be able to producethe extraordinary promised returnsthat would justify their exorbitantfees—doing so would require growinga tree of the genus . So somehedge funds, like the recently collapsedBayou, will hide poor performanceor losses through fraudulentmeans for a while before they getcaught; others will close at great lossesto investors.

The hedge fund industry will try toexplain away Bayou and other similarstories as isolated examples of badapples. But it isn't just that: the returnson many hedge funds havealready fallen below the market averages.Many of them are now likely totake extreme risks in the hope of surviving,which may lead to disastrousconsequences for their investors andeven the financial markets.

Uproot IMA Managers

Even if you avoid hedge funds, youmay ignore the First Law of Investingby succumbing to the siren song of personalattention, individualized portfoliomanagement, and the promise of superiorreturns of individually managedaccounts (IMAs) that almost all majorfinancial institutions are touting thesedays. However, there is no evidence norreason to believe that the IMA managerswill be able to earn better returnsthan the market averages. Even if theycan match the market, investors mayfare worse than the market because ofIMA fees. Worse yet, you may not beable to obtain reliable track records ofIMA managers.

Select Mutual Funds

I do believe that there are a handfulof exceptionally talented money managerswho can earn you superior returnsor reduce your investment risks, but ifyou want to find one of them, look inthe land of mutual funds and not IMAs.You can at least find reliable and longtermtrack records for mutual funds,and the fees may be lower. But be forewarned:It takes a lot of work andknowledge to identify the few outstandingmutual funds out of the 10,000existing funds, as well as their fundmanagers. Keep in mind that there ismore to successful long-term investingthan just finding one or two great funds.

Physician-investors should recognizethat financial institutions and theirsalespeople are more interested in signingyou up for a steady stream of highfees than your retirement security.Once you subject all investment opportunitiesto the First Law of Investing,you will become a much morediscriminating investor.

, author of The Only

Proven Road to Investment Success (John

Wiley; 2001) and Financial Modeling Using

Excel and VBA (John Wiley; 2004), currently

teaches finance at the Fordham University

Graduate School of Business and consults with individuals

on financial planning and investment management. He welcomes

questions or comments at chandansen@aol.com.

Chandan Sengupta