The trouble with taking charge of your own finances is the risk of falling for some kind of scam. Learning how to beat the vast majority of professional investors is easy: invest in index funds. But some people make the mistake of branching off to experiment with alternative investments.

Others wonder if they can find better index funds––those that promise to beat the market.

Achieving success with a new financial strategy can be one of the worst things to happen. If something works out over a one-, three- or five-year period, you’ll be tempted to try it again, to take another risk. But it’s important to control the seductive temptation of seemingly easy money. There’s a world of hurt out there and rascals keen to separate you from your hard-earned savings. In this chapter, I’ll examine some of the seductive strategies used by marketers who are out for a quick buck. With luck, you’ll avoid them.

Confession Time

Any investor who doesn’t have a story relating to a really dumb investment decision is probably a liar. So I’m going to roll up my sleeves and tell you about the dumbest investment decision I ever made. It might prevent you from making a similar, silly mistake.

Investment Newsletters and Their Track Records

In 1999, the same investment club mentioned earlier was trying to get an edge on its stock picking. We purchased an investment newsletter subscription called the Gilder Technology Report, published by a guy named George Gilder. He might still be in business. A quick online search in 2011 revealed a website boasting of his stock picks. It claims his picks have returned 155 percent during the past three years, and that if you buy now, you’ll pay just $199 for the 12-month online subscription to his newsletter. By 2016, the website was unchanged. It said the exact same thing.⁵

Back in 1999, we were convinced that George Gilder held the keys to the kingdom of wealth. Unfortunately for us, he was the king of pain. Today, if George Gilder reported his long-term track record online (instead of trying to tempt investors with an unaudited three-year historical return) he would have a stampede of exiters. His stock picks have been abysmal for his followers.

We bought the George Gilder technology report in 1999, and we put real money down on his suggestions. I’m just hoping my investment club buddies don’t read this book and learn that George Gilder could still be hawking promises of wealth. They’d probably want to send him down a river in a barrel.

Back in Chapter 4, I showed you a chart of technology companies and how far their share prices fell from 2000 to 2002.

In 2000, whose investment report recommended purchasing Nortel Networks, Lucent Technologies, JDS Uniphase, and Cisco Systems? You guessed it: George Gilder’s.

Table 9.1 puts the reality in perspective. If you had a total of $40,000 invested in the above four “Gilder-touted” businesses in 2000, it would have dropped to $1,140 by 2002.

And how much would your investment have to gain to get back to $40,000?

In percentage terms, it would need to grow 3,400 percent.

Wow—wouldn’t that be a headline for the Gilder Technology Report today?

High-Yielding Bonds Called “Junk”

At some point, you might fight the temptation to buy a corporate bond that’s paying a high percentage of interest. Ignore such investments. If a company is treading water or sinking, it’s going to have a tough time borrowing money from banks, so it “advertises” a high interest rate to draw riskier investors. But here’s the rub: if the business gets into financial trouble, it won’t be able to pay that interest. What’s worse, you could even lose your initial investment.

Bonds that pay high interest rates (because they have shaky financial backing) are called junk bonds.

I’ve found that being responsibly conservative is better than stretching over a ravine to pluck a pretty flower.

Fast-Growing Markets Can Make Bad Investments

A friend of mine once told me: “My adviser suggested that, because I’m young, I could afford to have all of my money invested in emerging market funds.” His financial planner dreamed of the day when billions of previously poor people in China or India would worship their 500-inch, flat-screen televisions, watching The Biggest Loser while stuffing their faces with burgers, fries, and gallons of Coke. Eyes sparkle at the prospective burgeoning profits made by investing in fattening economic waistlines. But there are a few things to consider.

Historically, the stock market investment returns of fast-growing economies don’t always beat the stock market growth of slow-growing economies. William Bernstein, using data from Morgan Stanley’s capital index and the International Monetary Fund, reported in his book, The Investor’s Manifesto, that fast-growing countries based on gross domestic product (GDP) growth produced lower historical returns than the stock markets in slower growing economies from 1988 to 2008.⁹

Table 9.2 shows that when we take the fastest growing economy (China’s economy) and compare it with the slowest growing economy (the US) we see that investors in US stock indexes would have made plenty of money from 1993 to 2008. But if investors could have held a Chinese stock market index over the same 15-year period, they would not have made any profits despite China’s GDP growth of 9.61 percent a year over that period.

China’s GDP continued to soar from 2008 to 2016. But the country’s stocks suffered. If $10,000 were invested in the iShares China Large-Cap ETF at the beginning of 2008, it would have been worth just $6,971 by October 10, 2016. By comparison, if $10,000 were invested at the same time in Vanguard’s S&P 500 Index, it would have grown to $14,792 by October 10, 2016.¹⁰

Yale University’s celebrated institutional investor, David Swensen, also warns endowment fund managers not to fall into the GDP growth trap. In his book written for institutional investors, Pioneering Portfolio Management, he suggests that from 1985 (the earliest date from which the World Bank’s International Finance Corporation began measuring emerging market stock returns) to 2006, the developed countries’ stock markets earned higher stock market returns for investors than emerging market stocks did.¹¹

In Table 9.3, I updated those returns to January 1, 2016. Emerging markets pulled ahead of developed world markets, excluding the United States. But they aren’t the runaway winners that many investors expect.

Emerging markets might be exciting—because they rise like rockets, crash like meteorites, then rise like rockets again. But if you don’t need that kind of excitement, you might prefer a total international stock market index fund instead of adding a large emerging-market component.

Whether the emerging markets prove to be future winners is anyone’s guess. They might. But it’s best to remain diversified and keep such exposure low.

Gold Isn’t an Investment

Gold is a horrible long-term investment. But few people know that. Do you want proof? Try this on the streets.

Walk up to an educated person and ask them to imagine that one of their forefathers bought $1 worth of gold in 1801. Then ask what they think it would be worth in 2016.

Their eyes might widen at the thought of the great things they could buy today if they sold that gold. They might imagine buying a yacht or Gulfstream jet or their own island in the South China Sea.

Then break their bubble. Selling that gold wouldn’t give them enough money to fill the gas tank of a minivan.

One dollar invested in gold in 1801 would only be worth about $54 by 2016.

How about $1 invested in the US stock market?

Now you can start thinking about your yacht.

One dollar invested in the US stock market in 1801 would be worth $16.24 million by 2016.¹²

Gold is for hoarders who expect to trade glittering bars for stale bread after a financial Armageddon. Or it’s for people trying to “time” gold’s movements by purchasing it on an upward bounce, with the hopes of selling before it drops. That’s not investing. It’s speculating. Gold has jumped up and down like an excited kid on a pogo stick for more than 200 years. But after inflation, it hasn’t gained any long-term elevation.

I prefer the Tropical Beach approach:

1. Buy assets that have proven to run circles around gold (rebalanced stock and bond indexes would do).
2. Lay in a hammock on a tropical beach.
3. Soak in the sun and patiently enjoy the long-term profits.

What You Need to Know about Investment Magazines

If investment magazines were created to help you achieve wealth, you’d have the same cover story during every issue: Buy Index Funds Today.

But nobody would buy the magazines. It wouldn’t be newsworthy. Plus, magazines don’t make much money from subscriptions. They make most of their money from ads. Pick up a finance magazine and see who’s advertising. The financial services industry, selling mutual funds and brokerage services, is the biggest source of advertisement revenue.

Advertisers pay the bills for financial magazines. That’s why you see magazine covers suggesting “Hot Mutual Funds to Buy Now!”

In 2005, I wrote an article for MoneySense magazine titled, “How I Got Rich on a Middle Class Salary,” and I mentioned the millionaire mechanic, Russ Perry (who I introduced in Chapter 1). I quoted Russ’s opinion on buying new cars—that it wasn’t a good idea, and that people should buy used cars instead.

Based on a conversation I had with Ian McGugan, the magazine’s editor, I learned that one of America’s largest automobile manufacturers called McGugan on the phone and threatened to pull its advertisements if it saw anything like that in MoneySense again. Financial magazines can’t afford to educate because advertisers pay their bills.

I had the April 2009 issue of SmartMoney magazine on my desk as I wrote this book’s first edition. The magazine was published one month earlier when the stock market was reeling from the financial crisis. Instead of shouting out: “Buy stocks now at a great discount!” the magazine was giving people what they wanted: A front cover showing a stack of $100 bills secured by a chain and padlock with the screaming headlines: “Protect Your Money!” “Five Strong Bond Funds,” “Where to Put Your Cash,” and “How to Buy Gold Now!”

Such headlines are silly when stocks are on sale. But if the general public is scared stiff of the stock market’s drop, they’ll want high doses of chicken soup for their knee-jerking souls. They’ll want to know how to escape from the stock market, not embrace it. Giving the public what it pines for when they’re scared might sell magazines. But you can’t make money being fearful when others are fearful.

I don’t mean to pick on SmartMoney magazine. I can only imagine the dilemma it faced when putting that issue together. Its writers are smart people. They know—especially for long-term investors—that buying into the stock market when it’s on sale is a powerful wealth-building strategy. But a falling stock market, for most people, is scarier than a rectal examination. Touting bond funds and gold was an easier sell.

Let’s have a look at the kind of money you would have made if you followed that April 2009 edition of SmartMoney.

It suggested placing your investment in the following bond funds: the Osterweis Strategic Income Fund, the T. Rowe Price Tax-Free Income Fund, the Janus High-Yield Fund, the Templeton Global Bond Fund, and the Dodge & Cox Income Fund.

Table 9.4 shows that with reinvesting the interest, SmartMoney’s recommended bond funds would have returned an average of 60 percent from April 2009 to January 2016.

How about gold, which was also recommended by that edition of SmartMoney? It would have gained 13.8 percent during the same period.

So far, it looks like the magazine’s recommendations weren’t too bad, until you look at what they didn’t headline. Stock prices were cheaper, relative to business earnings, than they had been in decades. The magazine headlines should have read: “Buy Stocks Now!”

Because they didn’t, as demonstrated by Table 9.4, SmartMoney readers missed out on some huge gains. Stocks easily beat bonds and gold from April 2009 to January 2016.

The US stock market (as measured by Vanguard’s US stock market index) increased 130 percent. Vanguard’s international stock market index rose by 86 percent, and Vanguard’s total world index rose by 123 percent during the same period.

The comparative results punctuate how tough predictions can be, while emphasizing that magazines cater to their advertisers and their reader’s emotions.

Hedge Funds—The Rich Stealing from the Rich

Some wealthy people turn their noses up at index funds, figuring that if they pay more money for professional financial management, they’ll reap higher rewards in the end. Take hedge funds, for example. As the investment vehicle for many wealthy, accredited investors (those deemed rich enough to afford taking large financial gambles), hedge funds capture headlines and tickle greed buttons around the world, despite their hefty fees.

But by now, it probably comes as no surprise that, statistically, investing with index funds is a better option. Hedge funds can be risky, and the downside of owning them outweighs the upside.

Don’t Buy a Currency-Hedged Stock Market ETF

There’s a mantra that Wall Street would probably like to banish. If it sounds too good to be true, it probably is. Wall Street, after all, will sell what Wall Street can sell. Such is the case with currency-hedged index funds.

They sound exotic. But they’re more common than a rusting third-world boat. In fact, when an ETF provider in Canada, Australia, or Europe first offers an international stock market ETF, they usually introduce a currency-hedged version first. They’re also being sold to US investors. Currency-hedged ETFs aren’t just rusting. They leak. That’s why I haven’t included currency-hedged ETFs in any of this book’s model portfolios.

Here’s what they’re supposed to do. Assume you’re an American who owns a European stock market index. If the stocks within the index gain 10 percent (measured in Euros) you would expect your index fund to earn something similar in US dollars. But reality could be different. If the Euro drops 10 percent, compared to the US dollar, Americans wouldn’t profit. A currency-hedged ETF, on the other hand, would still make money for American investors. At least, that’s the sales pitch.

Currency fluctuations, however, aren’t always bad. If, for example, the US dollar falls against most foreign currencies, then investors could profit from a nonhedged international index, as the growing strength of foreign currencies against the dollar juice the returns of a foreign stock index in US dollars.

With a diversified portfolio of domestic and nonhedged international stock indexes, sometimes you’ll win when currencies fluctuate. Sometimes you’ll lose. If the international market drops 5 percent, but the US dollar drops 8 percent against international currencies, Americans gain money if they’re invested in an international stock market ETF. On the flipside, if the international market drops 5 percent but the US dollar gains 8 percent against the index’s foreign currencies, the same investors would lose about 13 percent.

Currency-hedged ETFs are made to help you sleep. They’re made to limit fluctuations. But they have their own set of problems. First, their management fees are higher than with plain vanilla indexes. Second, they have higher hidden costs associated with the hedging itself. It’s where the leaking boat comes in.

In a PWL Capital research paper, Raymond Kerzérho examined the returns of S&P 500 indexes hedged to the Canadian dollar between 2006 and 2009. Even though the funds were meant to track the index, they did much worse. They underperformed the S&P 500 by an average of 1.49 percent per year. Currencies were less volatile between 1980 and 2005. During that period, tracking errors caused by hedging would have cost 0.23 percentage points per year. Add the higher expense ratios of currency-hedged funds and they would have underperformed nonhedged funds by about 0.5 percent a year.²⁰

The more cross-currency transactions that a fund makes, the higher its expenses—because even financial institutions pay fees to have money moved around. Consider the example of a currency exchange booth at an airport. Take a $10 bill and convert it to euros. Then take the euros they give you and ask them to return your $10. You’ll get turned down. The spreads you pay between the “buy” and “sell” rates will ensure that you come away with less than $10.

Large financial institutions don’t pay such high spreads. But they still pay them. And they reduce investors’ returns.

Then there’s the opportunity cost from the hedging itself. This gets a bit technical. But here’s a Cliff Notes version. When hedging currencies, there’s always a bit of money that gets left off the table. That money can’t make money. Mr. Kerzérho provides an example of a theoretical S&P 500 fund hedged to the Canadian dollar. Assume that it has $100 million (US) in assets under management. At the beginning of the month, it would be long $100 million in the US S&P 500. At the same time, it would be short $100 million—in US dollars—in foreign contracts versus the Canadian dollar.

If the US index gained 3 percent for the month, then it would be long $103 million (because of the rise in the US market). Considering that $100 million was short as a currency hedge, it would leave $3 million exposed and unhedged. If the US dollar drops, the $3 million in unhedged dollars will depreciate.

Because most financial institutions adjust their hedging once per month, fluctuations in currencies ensure that part of the assets are always underhedged or overhedged. If, for example, the S&P 500 lost money over the course of a month, then the fund would become overhedged. Using the figures above, if the $100 million long position dropped 3 percent to $97 million, the fund would be overhedged by $3 million—exposing it to potential losses on currency movements.²¹

Ben Johnson (the research analyst, not the doped former sprinter) published results from a 20-year US study in Morningstar. He says nonhedged ETFs usually beat their currency-hedged counterparts. “By hedging foreign-currency exposure, investors can mitigate a source of risk—but at the expense of a potential source of return.”²²

Stay away from currency-hedged ETFs. Long term, they’re leaking boats, compared to plain vanilla index funds.

Beware of the Smart Beta Promise

Marketers are smart. They’ve recognized that a growing number of investors are attracted to index funds. They smell opportunity. That’s why many have created smart beta funds, also known as factor-based funds. Do you remember what I said about Wall Street? If it sounds too good to be true . . .

Smart beta firms use backtests. They claim that index funds weighted differently produce better returns. For example, take a plain vanilla index. Its stock weightings will emphasize the largest stocks. If Apple is the largest company in the S&P 500, then Apple’s fortunes (good or bad) would have the greatest influence on the S&P 500. Smart beta indexes juggle the components differently. Sometimes, they build higher emphasis on stocks with momentum. Other times, they build an index that’s equal weighted. In this case, larger stocks don’t move the index fund’s needle any more than smaller stocks do.

Backtests usually dazzle. They prove that such index fund strategies would have triumphed in the past. But the past isn’t the future. Often, the newly emphasized stocks in these index funds become more expensive. This can hamper future returns.

Research Affiliates’ Rob Arnott, Noah Beck, Vitali Kelesnik, and John West say that smart beta or factor-based funds could disappoint investors. They recently published “How Can ‘Smart Beta’ Go Horribly Wrong?”²³ In it, they show that much of the past decade’s market-beating gains from such funds have come from rising valuations. Investors rushed into such funds because they had performed well. That raised the PE ratios of certain stocks to higher than normal levels.

Higher than normal valuation levels could bring poor returns in the future.

Smart beta funds are cheap, compared to actively managed funds. But they cost a lot more than most standard index funds. Strategies based on a cherry-picked past sell new Wall Street products. But they aren’t necessarily better for investors.

Don’t Jump Heavily into Small-Cap Stocks

Many people stack their portfolios with index funds that are heavily focused on small-cap stocks. And why not? Economists Eugene Fama and Kenneth French say that between July 1926 and February 2012, small-cap stocks cumulatively beat large stocks by 253 percent.²⁴ But not everyone agrees. That’s why investors should temper their small-cap expectations.

In 1999, Tyler Shumway and Vincent Warther published a paper in the Journal of Finance, “The Delisting Bias in CRSPs NASDAQ Data and Its Implications for the Size Effect.” They should have called it, “Size Doesn’t Matter.”²⁵

They said small stocks often have shakier financial foundations. They have a tougher time weathering storms. That’s why many get dumped (or delisted) from the stock market. Shumway and Warther say that when we measure small-cap returns, we only see the storms’ survivors.

Ted Aronson manages institutional money through AJO Partners. He runs two small-cap funds. But he doesn’t believe in the small-cap premium. Interviewed in 1999 by Jason Zweig, Aronson said, “Small-caps don’t outperform over time . . . Sure, the long-run numbers show small stocks returning roughly 1.2 percentage points more than large stocks . . . [But] the extra trading costs easily eat up the entire extra return—and then some!”²⁶

The firm Research Affiliates is always looking for a performance edge. They created the Fundamental Index in hopes of beating traditional cap-weighted index funds. Their researchers Jason Hsu and Vitali Kalesnik dug deeply into the apparent small-cap premium to see if small stocks really outperform. Based on their research, it appears that they don’t.

Following Fama and French’s research method, they split stocks into two groups for a variety of different countries. The largest 90 percent were put in one group. The smallest 10 percent were put in the other. They examined performances from 1926 to 2014.

After adjusting for extra transaction costs and delisting bias, Research Affiliates’ Vitali Kalesnik and Noah Beck say small stocks don’t beat large stocks at all. “If the size premium were discovered today, rather than in the 1980s, it would be challenging to even publish a paper documenting that small stocks outperform large ones.”²⁷

That’s why I like to keep things simple. Total stock market index funds include large-, small-, and medium-sized stocks. Those who do want a small-cap index should keep its exposure to a minimum.

When investing, seductive promises and get-rich-quicker schemes can be tempting. But they remind me of why I don’t take experimental shortcuts when hiking. It’s too easy to lose your way. I wonder if the famous French writer, Voltaire, would agree. In a translation from his 1764 Dictionnaire Philosophique, he wrote: “The best is the enemy of good.”²⁸ Investors who aren’t satisfied with a good plan—like simple index fund investing—may strive for something they hope will be “best.” But that path doesn’t pay.