Debunking the 2% and 5% Prudent Investor Allocation Rule

My wife and I have grown frustrated over the years watching the index funds in our employee-sponsored 401(k) plans grow, but not fast enough. As a solution, we decided to invest in individual shares in self-directed Roths and additional individual 401(k) plans outside of our employer-sponsored retirements.

The problem we faced then was finding the right individual actions.

If you watch a popular investment TV show or subscribe to a typical investment newsletter, you’ll get the advice to never put more than 2% or 5% into a single investment, or the like. Then the advisory service will work to feed you an extensive menu of recommendations.

You are expected to choose between 20 and 50 different actions.

I came across a study by New York University Stern Finance Professor Andrew Metrick in 1999 entitled “Assessing Performance with Transactional Data: Stock Picking from Investment Newsletters,” published in the #1 Journal of Investment. Finance.

Professor Metrick concluded that investment newsletter publishers lost out to a simple stock index fund. My frustration increased. I kept thinking…

There must be another way!

Ideas and advances came with time.

The most important was after having been trading and monitoring a large number of advisory recommendations from many sources. This was before, during, and just after the 2007-2008 accident. The silence of the newsletter editors was painfully false.

Every advisory service blindly recommended “buying opportunities” throughout the crash. None recommended sitting on cash.

That told me that investment advisory services were completely out of touch with the mainstream of the stock market as a whole. It became clear to me that the blind led the main street in the investment advisory industry.

If you can’t trade, you can always recommend.

The land of frequent and bad small bets

Our accounts were now filled to the brim with many stocks enthusiastically certified as “terrific” by the Wall Street investment newsletter services listed in Mark Hulbert’s Financial Summary. I was also in contact with many other subscribers due to my stature in finance.

Each complained about lackluster results from the counseling service’s recommendations.

Ironically, I was watching the accounts I helped manage with my sister-in-law double and triple in share after share. I didn’t have the energy to frantically churn through each account as the newsletter editors I followed recommended.

I was eagerly reading every new recommendation and dealing with many complicated buys and sells in small amounts.

The profits almost covered the losses. It was like playing slots tethered to a treadmill in a dark, dingy downtown Las Vegas casino.

The entire time I was directing his entire account to what I felt most strongly was the best stock in the market at the time. When the stock price’s uptrend weakened over time, the stops would take it out at a huge profit every two years or so.

Their returns exceed ours by a long mile. This did not please my wife.

He began to demand that I concentrate his portfolio. But I resisted.

Then the bomb fell. She had been working on an extensive study on newsletter bounces.

I remember the day Professor Eric Powers at the University of South Carolina gave me the bad news. Our study also showed that investment newsletters did not beat the market.

The reason investment newsletters can never beat the market is due to careful diversification. Let me explain.

Where cautious is “stupid” and “naive” is smart

Advice Service Editors are under the scrutiny of DRY.

His lawyers are terrified of Sauron’s federal financial red eye. Any investment newsletter publisher who recommends you invest 40% in a stock would be fired.

Yet this is exactly what Warren Buffet did with American Express stock in the 1960s. That concentrated investment turned into a huge profit for Berkshire Hathaway shareholders.

Prudent diversification is a cocoon for incompetent mutual fund money managers with uneven stock picks. Even more peculiar is that it makes it easy for a bad analyst or stockbroker to become an excellent publisher of advisory services on Wall Street; with enough sales charisma.

Recommending many stocks spread over small stakes makes the bad mix fade over time into average but severely attenuated long-term returns.

It became painfully imperative to stop chasing 20 to 50 advisor-recommended stocks that combined would never beat the averages. The constant churn bled my accounts in transaction costs and I really felt it.

It was better to naively diversify into 500 stocks at once.

Naive diversification is best achieved by simply buying 1 index mutual fund. A good example is the Vanguard 500 Fund (VFINX).

It has low turnover and low fees. And it generates a naive diversification into more than enough stocks to achieve a full average.

In an employer-sponsored 401(k) without naive self-direction is smart diversification.

The 3 Stock Portfolio of Uncommon and Good Big Bets

My best advice to any family financial manager looking for high returns is to focus on no more than 3 stocks in your Roth and individual 401(k). But get the best of both worlds. Be sure to index your employer-sponsored 401(k) plan—ours has grown amazingly despite the boredom.

They say that teachers teach what they do not know how to do. Think again.

If John Maynard Keynes could become a millionaire in the stock market, so can you!

REFERENCES

Claire Emory. 2013. Do investment newsletters move markets? (Abstract summary). Abstract CFA 43(3). 315-338.

Andrew Metrick. 1999. Evaluating Performance with Transaction Data: Stock Picking from Investment Newsletters. The Journal of Finance 54(5). 1743-1775.