In Part I of this series I talked about how important it is to come up with an accurate rate of return when doing financial planning.

In Part II I talked about my asset allocation being 100% stocks and some of my rational for that and briefly touched on some of expected rates of returns for stocks and some of the reasons why most individual investors can’t attain those rates.

In Part III of this series I am going to try to justify why I am not following the smart path of investing in index funds.

First off let me start out this post by saying that if I were giving advice for someone else to follow I would recommend that they put all of their stock investment money into index funds. They are the most consistently successful way to invest in the stock market and in the long run for the very large majority of people will provide them the best long-term returns in the stock market.

Now here’s where the hypocrisy starts and I welcome anyone to call me out on any of my rational. I do not own any index funds.

Despite the overwhelming statistics that individual investors picking stocks and actively managed mutual funds fail to beat the markets average around 80% of the time I am trying to be one of those people who beats the odds. Here is my rational.

1. When I hear the word average I associate that with poor performance. Not trying to sound arrogant here, but generally in life I’ve found myself above the “average” bar. I mean look at the average American. The average American got C’s in school, doesn’t graduate from college, has a 0% savings rate, doesn’t pay off their credit card every month, buys a new car every few years, is woefully under prepared for retirement, is overweight, lives paycheck to paycheck, and doesn’t read 72 finance blogs and financial websites a day :P.

I generally tend to put a little more effort into things than the average person and this usually pays off for me. Most people who invest in individual stocks don’t spend the time to learn enough to be successful. The want fast results with little effort and that pretty much epitomizes the qualities and end results listed above. I love finance and love using my mind to make me money, so when it comes to investing I tend to think maybe I have some of the qualities that might lead me to into that minority that beats the market averages.

The above points kind of explain why the average person doesn’t beat the market, but I think it’s also important to look at the “average stock” to see why I am optimistic that I can beat the average stock market returns. As was kind of pointed out above average includes everything. Even though most people you may know have a college degree, got Bs in college, doesn’t carry credit card debt, etc. you have to include all the people that dropped out of high school, are on drugs, can’t get a job, and have racked up hundreds of thousands in debt and declare bankruptcy. Granted the other end of the spectrum (Warren Buffett, Bill Gates) is included too, but you get my point.

Even though the average stock market return is roughly 10% it includes lots and lots of very bad stocks. Stocks of bad businesses with no profits and poor business models. Now granted hindsight is everything, but without a whole lot of effort you can likely weed out a very large chunk of stocks that are bound to perform poorly. Of course you will have your Enrons and WorldComs where everything seems nice and peechy and then crap hits the fan, but that is why you diversify your holdings. No one or two stocks should be able to sink your portfolio overnight. But getting off-topic here a little, and I’m already writing a book. In summary I think I can work to be an above average investor and that I’ll use those skills to pick above average stocks.

2. Even though this is not great logic, I’m young and feel that I can afford to take some risks, maybe I have some knack for investing and it would be a shame to at least not give it a try to see if maybe I can beat the market. If it turns out that 5 to 10 years down the road I can’t earn above average returns, yes I will have potentially thrown away some returns by not at least meeting the average, but even if I earn 0% or even lose money I will still be better off than a very vast majority of people when it comes to retirement nest egg, will have learned my lesson, and can switch my money over to index funds, and still be able to enjoy a comfortable retirement .

3. A vast majority of mutual funds are very short-sighted and don’t invest for the long-term. They are judged by their performance over the last year or quarter and not over decades. Most investors don’t have the patience to wait out a few bad years and so mutual funds are constantly jumping in and out of stocks trying to churn a fast profit to get more people to throw their money into the fund. This in turn creates poor performance in the long-run and I think skewes the results that can be attained by doing your due diligence up front and holding the same stock for 5,10, or 20 years. So that statistic that 80% of mutual funds don’t beat the market average can be largely attributed to the fees that it costs for holding the mutual fund and the fees the mutual fund itself incurs by trading in and out of stocks so much chasing short term gains, and not as much about how incredibly difficult it is to choose good long term investments.

4. I’ve been drinking too much of the Kool-Aid over at Fool.com and feel empowered as an individual investor. After visiting their site daily for a couple years I went a head and subscribed to one of the stock picking newsletters run by Tom and David Gardner themselves. While I don’t necessarily agree with anyone who just goes and buys stocks based on what some investing guru says (Ex: Jim Cramer), I have really bought into the Fool philosophy of investing (sip…..mmm good kool-aid) and best of all a long with stock picks that have a pretty darn good track record (roughly 25% annualized returns in the four years its been around), they provide pretty in depth analysis on why they choose the stock and there are tons of resources (much like in the pf blogging community) that are full of great ideas and advice on how to better improve your stock picking prowess. Anyway I’ve been using some of the picks generated from this service to narrow down stocks that I buy for my and my wife’s Roth IRAs. So I’m kind of cheating off someone who has the time and skills to do a lot of the grunt work for me.

So what does this mean for my expected rate of return? Well theoretically I should maybe bump it up a few percentage points if I truly do believe I can beat the market, but I am not necessarily confident I will be able to do so and I may very well fall flat on my face. So despite my lofty ambitions I will leave my return rate at whatever I deem to be the average for the stock market as a whole, probably 10%. This will kind of be my benchmark to weight my actual returns against. If 5 to 10 years down the road it turns out that I am only meeting this average or worse yet losing to it, then it does not make sense for me to put the extra effort and risk into picking individual stocks and will switch to index funds and will be able to leave my rate of return in my calculations the same.

Ok and now that I have come to the end of this long rambling post about personal investor empowerment and above average reutns I just realized I’ve sort of been misleading you through this whole post. I actually do own index funds. In fact my 401k which makes up roughly half of my retirement savings is invested in various index funds. So I guess take that into account before you let me know I’m a complete fool for risking money in individual stocks without having a clue what I am doing. Again I’m definitely open to criticism.

In part IV I will talk about inflation and how I usually go about taking this into account in my calculations.

Part I  – Introduction
Part II – Asset Allocation

[tags]Investing, Annualized Return, Financial Planning[/tags]