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David Swensen's Advice for the Individual Investor

Swensen shares more investing advice in his book <em>Unconventional Success.</em>
Swensen shares more investing advice in his book Unconventional Success.

Beware of the Mutual Fund Myth: Many Americans seem to like the idea of pooling their money in an actively managed mutual fund -- where, presumably, a professional money manager can invest it better than they could themselves.

But Swensen says that doesn't work. He says for-profit mutual funds have an inherent conflict of interest. They make money by charging fees that suck profits away from investors in the funds. In fact, over time -- when you factor in the fees, taxes and other costs -- he says your odds of beating the market in an actively managed fund are less than one in 100.

Most mutual funds get far too big and own far too many stocks, Swensen says. In Unconventional Success, he writes that, when a fund is holding 30 to 50 stocks or more, the odds become very likely that the fund will start to track its broader market category. Stock picking becomes less important as the winners and losers in the fund average out much like the broader market. So why pay someone a lot of money to pick stocks?

He says mutual fund investors also lose from commissions and market impact associated with all the churn -- that is, the buying and selling of stocks in the fund.

Invest in Nonprofit Index Funds: Since at least 99 percent of mutual funds aren't going to beat the overall market, Swensen says individuals should invest in nonprofit funds that track market segments, such as the S&P 500. There are a range of index funds that track the U.S. domestic stock market, international markets, emerging markets and the real-estate market.

Swensen says mutual funds that are organized on a not-for-profit basis don't have the same conflict of interest as for-profit funds, and they charge lower fees.

The fees are even lower with nonprofit index funds, because you're not paying money managers to research stocks and buy and sell them. The fund simply holds all the stocks listed in that index. And because well-structured index funds have low churn (turnover), they are remarkably tax efficient.

Pick the Right Investment Mix and Keep Your Money There. Don't Move It Around! Swensen says that individual investors will make the greatest return by focusing on the right way to carve up their portfolio into different areas of investment (see the pie chart at top left). He says they should then stick with that mix.

Don't, for example, try to decide when to buy U.S. stocks and sell a lot of bonds, in an effort to predict which way those markets are heading. If you do that, he says, you're going to lose over time, because you'll be competing directly with professionals like him.

Swensen has a team of 20 analysts -- and a small army of boutique investment houses -- working long hours to predict which way certain market segments or individual stocks will move. Who do you think is going to buy and sell at the right time? Remember: If somebody buys low and sells high, somebody else is buying high from them. You don't want to be that person.

Rebalance Your Portfolio: Swensen rebalances his portfolio at Yale at least every day, and often many times throughout the day. What does that mean?

Let's say U.S. stocks go up 2 percent one afternoon, while international stocks decline by 1 percent. If you have holdings in both areas, the percentage of your portfolio that's in U.S. stocks has grown a bit, and the foreign-equity portion has shrunk a little. Over time, this process can really change the face of your portfolio -- especially if you continue to reinvest your earnings, or make contributions to a 401k or 403b, without ever rebalancing.

So, Swensen says, you need to regularly rebalance your holdings to keep them steady. That way, when the value of foreign stocks or emerging-market stocks rises, you'll own more of them -- and will make more money -- if you rebalanced while these stocks were cheaper.

Adjust Your Portfolio as You Near Retirement: As you get older and closer to retirement, it's obviously important to have enough money in less risky, more predictable investments.

But rather than changing all the numbers on your "asset allocation" pie chart depending on your age, Swensen prefers to think about this question in a way that's easier to grasp. He says as people age, they can keep their investment portfolio set up the way it always has been. But they should start to move money out of it, across all investment categories proportionally, and transfer the money into an account that's invested in money-market funds or short-term, inflation-indexed bonds.

-- Chris Arnold

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