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When I began work as a financial planner in 1988, I would spend hours studying Morningstar Mutual Fund reports to determine the best funds to help my clients reach their goals.  The reports contained volumes of data, but experience taught me they did very little to predict how the funds would perform in the future. 

Retail mutual funds were over-hyped when they performed well, regardless of whether the high returns were due to the investment category they focused on (tech stocks in 1999) or a manager’s streak of luck in stock selection.  All the attention invariably caused new investors to buy in, chasing after the high return.  The next year, flooded with too much cash to invest in an asset class that had already experienced a great year, the mutual fund usually disappointed and people pulled out what was left of their money, angry that the fund hadn’t lived up to their expectations.  And the cycle began all over again. 

We realized this wasn’t the best plan for creating and maintaining wealth for our clients many years ago, so we began using funds that were not available to the general public.  This accomplished two things.  Clients weren’t investing in funds where buyers would flow in during good times and out during the bad, so their returns weren’t reduced by emotion-driven cash flows.  They also weren’t subject to higher expenses inherent in most retail mutual funds.  The management fees disclosed in Morningstar reports carried an average cost of 1.5%, with many higher, plus there were other expenses such as 12(b)1 fees (used to pay for marketing the funds) and higher turnover and trading expenses that were not as well known. 

Moving from retail funds to institutional funds was the first step to improving our clients’ investing results. 

A few years later we added funds managed by Dimensional Fund Advisors (DFA)to our clients’ portfolios.  At the time, DFA was unknown to most investors, and we spent much of our time educating people about who they were and how they approached investing differently.   DFA has no superstar, stock-picking fund managers that appear on TV.  Instead, they follow a disciplined approach toward investing that involves minimizing costs, spreading risk among a broad selection of holdings, and utilizing on-going academic research to create and apply various screens to determine what stocks and bonds to hold in their funds.  Using this approach, 75% of their funds have beaten their category benchmarks over the past 15 years, and 80% over the past 5 years according to Morningstar. 

All this success has started to attract attention.  CNN Money’s recent article, David Booth Beats the Market Without Picking Stocks, outlined the company’s success.  Barron’s cover article, A Different Dimension, appeared on January 4th.  And Eugene Fama, the professor at Chicago School of Business whose teachings inspired Ph.D. students David Booth and Rex Sinquefield to create DFA in 1981, recently won the Noble Prize in Economics.   

While DFA’s funds have been an excellent tool for implementing our clients’ investment plans, holding a great mutual fund is only one step to successful investing.  The biggest determinant of success is how you go about investing in those funds.  Investing is very emotional, and our emotions, namely fear and greed, often sabotage other good decisions.  Our best instincts tend to do us no good in financial markets. 

In the midst of the Great Recession many investors began to believe the losses would go on forever, and wanted to get out and save what was left.  Fear reasonably told them to get out when the S&P 500 fell over 38%.   

Similarly today, people excited about 2013 stock returns are beginning to forget that fear.  Now, that same instinct that wanted to be fearful at the bottom says to add more to stocks.  Today bonds are the new ‘bad investment’ with low interest rates and a fear of future principal loss.   

That’s not to say the market is at the top or anywhere near it.  It simply illustrates the point that no one can be sure.  Chasing great returns, bailing out of bonds or stocks while they’re down, and generally allowing our emotions to whip us in and out of investments at inopportune times cripples our results no matter how great our investment choices.   

The first and most important step to successful investing is choosing the appropriate combination of stocks and bonds that’s right for you.  Experience has taught us it’s a compromise between what you need to earn to meet your goals and what your nerves can handle.   Once that balance is set, you should take risks only in areas where you will be rewarded, and use market jumps and drops to your advantage by rebalancing to your appropriate mix.   

Focus on the first step, and you’ll be a long way toward investing successfully.