Investing Tip of the Month

In Investing, 'I Don't Know' Can Be the Right Answer, by Christine Benz, Director of Personal Finance and Editor of Morningstar PracticalFinance.

A reporter recently asked me a question that stumped me. In response, I said, "I don't know."

"You're my hero!" he said. "No one ever says they don't know!"

Well, I do, and I think you should, too--particularly when it comes to making certain investment decisions.

That's because investing, at its heart, entails a lot of uncertainty. Part of the uncertainty stems from investors' own tendency to act on their emotions rather than on the cold, hard facts. Scores of studies of investor behavior have shown that individual investors often become overly exuberant and exhibit risk-tolerant behavior in up markets only to pull in their horns when the markets are in the dumps.

And even when you've done your homework on a security, it's usually impossible to say that it will definitely go up or down and by how much, particularly if it's a new company or operates in a volatile industry. To reflect that there's a range of outcomes for any stock, last year our equity analysts rolled out Uncertainty Ratings for the companies they cover.

For a similar reason, you should question any market prognosticator's ability to forecast a precise value for the Dow by year-end or the direction of a given currency. Think, for a second, about the dizzying number of factors you'd have to get your arms around to correctly forecast the value of the dollar versus the euro by year-end. You'd have to have a pretty clear knowledge of where the U.S. economy was headed, of course, but you'd also have to draw a bead on the economic health of Europe and all other large economies, as well as interest rates, inflation levels, and geopolitical factors. If that seems downright impossible, you're right.

In a similar vein, I'd argue that there are no black-and-white answers to many investing debates, both the big ones (is it better to own individual stocks or mutual funds?) and smaller ones related just to your portfolio (should I sell the fund that just had a manager change?). You can stack the deck in your favor by investing based on where you think the preponderance of evidence lies, but also put in place a slight hedge in case you're wrong.

Here are some of the key debates where "splitting the difference" is apt to be the right course of action.

1. Index Mutual Funds vs. Actively Managed Funds
The debate about whether you're better off buying an index fund that passively tracks a market benchmark or buying one run by an active stock-picker has been simmering steadily for years. It's irrefutable that many active stock-pickers don't earn their keep, and I've long said that you can do just fine with an all-index fund portfolio (or an all-ETF portfolio, for that matter). By the same token, I don't think you'll go too far wrong if you stick solely with top active managers like the ones who populate Morningstar's Fund Analyst Picks list.

However, perhaps a better course of action for many investors is to do both, according to a recent study by the Vanguard Group. Based on the firm's analysis of more than 200 million different portfolio combinations, even those portfolios composed entirely of funds run by top managers exhibited an improved risk/reward profile when a dose of index funds (accounting for roughly 25% or so of the overall portfolio) were thrown in for good measure. (Before you complain that Vanguard has a horse in this race, thanks to its indexing prowess, it's also worth noting that the firm fields scores of actively managed funds.)

These findings translate perfectly into real-world portfolio management. If you have a lot of confidence in your ability to pick talented managers (and your real-life investment results back up your assertion), go ahead and invest the bulk of your retirement portfolio (that is, your 401(k) and IRA) in active funds. Your retirement account is the better place to hold actively managed funds because such funds are likely to be less tax-efficient than index funds; in addition, you won't trigger taxable gains if you decide to switch one of your holdings.

At the same time, consider devoting at least part of your taxable portfolio to a broad-market index fund or ETF. Plain-vanilla index funds are extremely tax-efficient and can serve to damp the volatility associated with your active funds' holdings.

2. Stocks vs. Funds
As with the indexing versus active question, here's another debate where the combatants often imply that the decision is absolute: You're either with them or against them. Stocks are too risky and time-consuming, the fund geeks argue, whereas the stock jocks sometimes imply that funds are strictly for girly men (or girly girls).

True, an all-fund portfolio can make sense for investors who are in search of low- to no-maintenance portfolios. And I know many investors (including several in our stock-analyst ranks) who have generated healthy returns using all-stock portfolios.

For most investors, however, stocks and funds can coexist peacefully in a portfolio as long as they're not overlapping too much. If you have an S&P 500 Index fund, for example, it's probably unwise to also have a big position in ExxonMobil (XOM). (In Morningstar Investment Research Center's Portfolio X-Ray tool there is a Stock Intersection feature that helps you check for overlap.)

As with index funds, you may want to concentrate your stock-investing efforts in your taxable accounts. That's because stock-only portfolios tend to be more tax-efficient than those involving funds, because you only pay taxes when you yourself sell a stock in which you have a gain. You might also think about holding stocks in the sectors and industries that you truly understand. In areas where you have less hands-on experience or where the information flow may be scant--say, in emerging markets--you're better off delegating security selection to a portfolio manager who's a specialist. Our Fund Analyst Picks list is a good starting point if you're in search of funds run by best-of-breed managers. If you're looking for high-conviction stock ideas, use our Stock Screener to look for those rated 4 or 5 stars with a fair value uncertainty rating of medium or lower.

3. Selling vs. Holding On
I often hear from readers who are wrestling with whether to sell a mutual fund, either because performance is in the dumps or a fund manager has left. The question is usually, "Should I stay or should I go?"

Sometimes, the answer is pretty obvious. If your tame bond fund has jacked up expenses from 0.5% to 1.5%, or if the CFO of a company whose stock you own has fled the country after apparently cooking the books, the answer is pretty easy: Sell it.

But in other situations, the decision is less than clear-cut. Even if you have reason to believe that you'd be better off in some other stock or fund than the one you own, you also have to factor in the tax and transaction costs associated with the trade. If you're not sure that you'll out-earn those transaction costs in the form of higher returns in the future, you may be better off staying put in your less-than-perfect stock or fund.

There is a middle ground, however, yet it's one that many individual investors don't often consider. Why not sell a portion of your shares and hang on to the rest? That can be a particularly effective strategy if you've already made a nice profit in a fund or stock. You can sell a portion, effectively locking in your gains, yet hold on to some of your shares to hedge against the possibility that you're selling prematurely.

4. Roth IRA vs. Traditional Deductible IRA; Traditional 401(k) vs. Roth 401(k)
Here's a smaller-scale portfolio-management question but one that's relevant for many investors: Assuming you're eligible for both, are you better off contributing to a Roth IRA or a traditional deductible IRA? What about investing in a traditional 401(k) versus a Roth 401(k)? In both the traditional deductible IRA and 401(k), you don't pay taxes on your contributions but are taxed on your withdrawals. If you opt for the Roth IRA or 401(k), you contribute aftertax dollars but withdrawals are tax-free.

For this one, I'd go back to my original point about uncertainty. The decision about whether to invest in a traditional 401(k) or IRA versus a Roth rests on two key questions: What tax bracket are you likely to be in when you retire, and do you expect federal tax rates to be higher or lower at that time? Needless to say, those questions are pretty close to unanswerable (unless you're a time traveler, that is).

For that reason, I'd say that the right answer to this question is to split the difference, thereby diversifying the future tax treatment of your 401(k) and IRA assets. If you already have a lot of assets built up in a traditional IRA or 401(k), it makes sense to opt for the Roth for your future contributions. Those who have been unable to contribute to a Roth IRA because they earn too much have a particularly strong incentive to consider the Roth 401(k), because without it, all of their tax-sheltered assets will be taxed upon withdrawal.

5. Mortgage Paydown vs. Investing in Stocks and Bonds
Similar to the 401(k) question above, this one lands in the realm of capital allocation. At the crux of whether to pay down your mortgage aggressively versus investing in the market is an unknown variable: Will your investment returns be able to out-earn your mortgage interest rate? Because you don't know the answer to that question, most investors, particularly those who are paying private mortgage insurance or who don't enjoy much of a mortgage-interest tax deduction, should chip away at their mortgage principal on a more aggressive schedule than their lenders require.

How aggressively, you ask? That depends on your asset-allocation mix. If you're young and have the bulk of your portfolio in stocks, you at least have a fighting shot at outgunning your mortgage interest rate, even on an inflation-adjusted basis. If, however, your portfolio is heavy on cash and bonds and you're carrying a big mortgage, extra payments toward your mortgage principal are a better use of your household capital.

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