If you read the popular personal finance press, you’d think that mutual fund investing comes down to a choice between index funds and actively managed funds.

Those who favor indexing love to point out how few actively managed funds beat their benchmarks each year, and of those that do, how few can sustain their success. Those who favor actively managed funds stick to their beliefs that in the hands of a good manager, an actively managed fund really can beat the market.

To a casual observer, indexers seem to have the facts on their side. For example, consider a recent study by S.&P. Dow Jones Indices. It found that just two out of 2,862 actively managed mutual funds whose performance put them in the top 25% of those funds five years ago stayed in the top 25% for each of the next four years.

A New York Times article about the actively managed mutual funds study said it “provides new arguments for investing in passively managed index funds.”

But does it? The article actually highlights the typical way the financial press writes about mutual fund investing—that there are only two paths: index funds or buying and holding actively managed funds.

Sound Mind Investing members know there’s a third path: using objective, mechanical guidelines to actively manage a portfolio of actively managed funds. That’s what we do with Fund Upgrading.

Our recommended funds are those that are currently winning—those with the highest momentum based on recent past performance. But we have no expectation that those funds will continue to outperform indefinitely. And in fact, when a fund’s momentum wanes, it is replaced with a fund showing stronger momentum.

It’s a strategy that has generated very satisfying, long-term market-beating returns.

Long-time SMI members may take the third path for granted. But especially for newer members, it’s important to keep the distinction of this third path in mind—especially since the typical reporting about mutual fund investing seems capable only of seeing the two paths of index funds or actively managed funds.

With apologies to Robert Frost,

Three roads diverged in a wood, and I—

I took the one less traveled by,

And that has made all the difference.

When you read the usual debates between index funds and actively managed funds, do you ever remind yourself that there’s a third path for mutual fund investors?

Matt Bell

By Matt Bell

Matt Bell is Sound Mind Investing’s Associate Editor. He is the author of three personal finance books published by NavPress, leads workshops at churches and universities throughout the country, and has been quoted in USA TODAY, U.S. News & World Report, and many other media outlets.

Today I have a very interesting and informative article from the New York Times that first appeared in 2011. Don’t let the fact that it’s three years old put you off—the author’s observations on the human side of investing are always timely.

It was written by Daniel Kahneman, author of our cover article last year at this time, Intuitions vs. Formulas (membership required). This article is excerpted from the same book as was our cover article.

I like running articles on the psychology of investing because, as I’ve pointed out many times, we are our own worst enemies when it comes to making good investment-related decisions. Any insights that will help us manage ourselves better are welcome.

The article is a little longish but well worth your time. Here are a few excerpts to whet your appetite:

The confidence we experience as we make a judgment is not a reasoned evaluation of the probability that it is right. Confidence is a feeling, one determined mostly by the coherence of the story and by the ease with which it comes to mind, even when the evidence for the story is sparse and unreliable….An individual who expresses high confidence probably has a good story, which may or may not be true…

Many individual investors lose consistently by trading, an achievement that a dart-throwing chimp could not match. The first demonstration of this startling conclusion was put forward by Terry Odean…

In a paper titled “Trading Is Hazardous to Your Wealth,” Odean and his colleague Brad Barber showed that, on average, the most active traders had the poorest results, while those who traded the least earned the highest returns.

In another paper, “Boys Will Be Boys,” they reported that men act on their useless ideas significantly more often than women do, and that as a result women achieve better investment results than men…

Individual investors like to lock in their gains; they sell “winners,” stocks whose prices have gone up, and they hang on to their losers. Unfortunately for them, in the short run going forward recent winners tend to do better than recent losers…

Mutual funds are run by highly experienced and hard-working professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless…at least two out of every three mutual funds underperform the overall market in any given year.

How do we distinguish the justified confidence of experts from the sincere overconfidence of professionals who do not know they are out of their depth? We can believe an expert who admits uncertainty but cannot take expressions of high confidence at face value…

Overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.

It might seem that I may be undermining my own credibility when I quote a suggestion that professionals who “sincerely believe they have expertise” may be self-deluded. The key word in the quote in “overconfident.” We have never been overconfident. As I’ve written  before, we make “no pretense that we know what the future holds.” That’s why we rely on mechanical trend-following strategies.

Ironically, our humble admission of uncertainty, according to Kahneman, makes us experts you “can believe,” in whom your confidence is “justified.” Just another strange and unexpected turn of events in the upside-down world of investing.

Austin Pryor

By Austin Pryor

Austin Pryor has three decades of experience advising investors, and is the founder of the Sound Mind Investing newsletter and website. Austin lives in Louisville, Kentucky, with Susie, his wife of 46 years. Two of his sons, Andrew and Matthew, work with him at Sound Mind Investing. A third son, Tre, is a RealtorŪ in the area.

This week’s picks for the best in personal finance from around the web.

Who routinely trounces the market (NY Times). This is why we believe in “fund infidelity,” only staying with funds as long as they’re winning.

SEC ends $1 a share for some money funds (USA TODAY). So far, this only impacts institutional money market funds. So far.

Greenspan says bubbles can’t be stopped without ‘crunch’ (MarketWatch). The former Fed Chairman on stock market bubbles and human nature.

IRA contributions: the perils of procrastination (Reuters). When you make your contributions matters more than you may realize.

How brands make the man, and the woman—literally (PBS). How large a role do brands play in your life? Are you sure?

And from the blogosphere…

Three portfolio risks you may be overestimating (Morningstar). The danger of inadvertently taking on more risk in some areas of your portfolio while trying to lower risk in others.

Your mind, your investment returns (Barry Ritholtz – Bloomberg View). When facts collide with beliefs, unfortunately, beliefs usually win.

The bulls just got the inflation news they were hoping for (Business Insider). You may be paying a lot at the pump and the grocery store, but from an investor’s perspective, the inflation numbers that matter most look good.

What you think about inflation is wrong (Bloomberg View). Don’t worry; the government’s view of inflation does take energy and food costs into account when making Social Security cost-of-living adjustments.

An eye to the past can help guide the future (Sketch Guy – a NY Times blog). Knowledge and the circle of wisdom.

We’d love to hear your responses to any of the above. To weigh in, just meet us in the comments section.

Matt Bell

By Matt Bell

Matt Bell is Sound Mind Investing’s Associate Editor. He is the author of three personal finance books published by NavPress, leads workshops at churches and universities throughout the country, and has been quoted in USA TODAY, U.S. News & World Report, and many other media outlets.

For many years, popular personal finance teaching, especially in churches, has steered people away from credit cards and toward debit cards. But recent credit and debit card data breaches, such as the massive one experienced by Target shoppers, shows why credit cards may be the better way to pay with plastic.

The Argument For Debit Cards

Debit card proponents come from a “save yourself from yourself” perspective. They point out that you can’t get too reckless with a debit card since its pulling real money from your checking account. With credit cards in your wallet, they worry that you may head to the store for milk and eggs only to come home with a new bass boat!

With a credit limit far exceeding the balance most people keep in their checking account, they argue that carrying a credit card is like walking around with a stick of dynamite in your wallet. There’s no telling when that thing might go off, blowing up your financial life and probably taking your marriage with it.

The Argument for Credit Cards

The Target mess, and similar ones at other retailers, made a lot of people rethink their use of plastic. Hopefully, it reminded people of one very important difference between debit and credit cards.

If someone buys something fraudulently with your debit card, that money has been pulled from your checking account. Now, your recovery efforts are all about getting your bank to put the money back. While many debit card issuers have zero-liability policies (as long as you sign for your purchases instead of using your PIN), banks have up to 10 days to investigate fraudulent debit card use. In the meantime, your lower account balance may leave you bouncing checks.

By contrast, if someone buys something fraudulently with your credit card, that money has not been pulled from your checking account. Instead, it shows up on your bill, giving you time to contact your card issuer and make sure you don’t have to pay for that item.

Credit Card Rules of the Road

To be sure, there are some people who would be better off not using credit cards. The temptation to overspend really is too much. However, I believe many people (and most SMI readers) are capable of using credit cards responsibly. Here are four “rules” that help.

First, use a credit card only for pre-planned purchases. If your cash flow plan (a.k.a. your “budget”) says you can spend $100 on clothing each month, you are free to use a credit card to buy $100 of clothing each month. Of course, this assumes you have a cash flow plan. I would go so far as saying if you don’t use a cash flow plan, don’t use credit cards.

Second, record your credit card spending right away. If you’re using an electronic cash flow tracking system, such as Mint.com, it’ll do this for you. If you’re using a paper & pencil tracking system or some other manual process, record your spending on the day you make each credit card purchase, even though the bill won’t show up for several weeks. Today’s credit card purchase counts against this month’s budget.

This is one of the most important ways to avoid overspending with a credit card. Too many people wait until the bill arrives, which often prompts them to think the credit card company made a mistake (“I couldn’t possibly have spent that much!”), only to find out they really did make all those purchases.

Third, pay your bill in full each month.

And last, if you can’t follow rules one through three, don’t use credit cards.

Heretical Teaching?

In our household, we only use a debit card when depositing checks or getting cash. For all other plastic-related transactions, we use credit cards.

Saying that feels like revealing a deep, dark secret. The teaching against credit cards and in favor of debit cards, especially in church circles, has become so visible and impassioned that it’s easy to assume it must come straight from the pages of Scripture. But it doesn’t. God’s Word teaches us to be wise. In today’s environment of frequent data thefts, if you’re going to use plastic, I believe using credit cards is wiser than using debit cards.

What about you? Which form of plastic do you prefer and why?

Matt Bell

By Matt Bell

Matt Bell is Sound Mind Investing’s Associate Editor. He is the author of three personal finance books published by NavPress, leads workshops at churches and universities throughout the country, and has been quoted in USA TODAY, U.S. News & World Report, and many other media outlets.

The Fed’s policy of buying government bonds by the billions-of-barrels full (controversial in some quarters because it’s essentially printing money and debasing the U.S. dollar) is coming to an end this fall. Here’s a brief history review from the Washington Post:

For the past year and a half, the Fed has been buying tens of billions of dollars in government bonds and securities each month in an attempt to tamp down long-term interest rates and boost the recovery. It was the third and largest bond-buying program the central bank has launched since the 2008 financial crisis. But officials have been slowly scaling back the effort this year, and documents released Wednesday show that the Fed’s policy-setting committee is nearly ready to call it quits….

The bond-buying programs, also known as quantitative easing, have been credited with pushing mortgage rates to historic lows, breathing life into the moribund housing market and fueling a boom in refinancing…. The bond purchases have also helped send stock markets to record highs, with the Dow Jones industrial average crossing 17,000 last week. The index has hit a new high 14 times this year. But skeptics worry that the Fed could be setting the stage for another financial bubble…

The QE programs have kept short-term interest rates near zero since 2008, and the big question now is when might the Fed begin, at long last, to raise them. According to Sy Harding’s reporting, it might be sooner than expected:

The Fed now says it will use a range of economic data to decide when to begin raising rates, with its emphasis on inflation. It indicated the first rate hike will probably not be until late next year. However, with some signs that inflation is beginning to rise faster than the Fed expected, pressure is building for the Fed to consider raising interest rates sooner.

Even some Fed officials are in that camp. Charles Plosser, president of the Philadelphia Fed, said this week that, “We should not keep rates at zero until we meet all our economic objectives.” He warned waiting too long could be disruptive, that rates would have to rise faster and higher if the Fed gets behind the curve. Kansas City Fed President Esther George said this week that some of the indicators the Fed looks at are pointing to a possible rate hike as early as this year (emphasis added).

That is not the consensus of Fed officials, but raises the possibility of more dialog in that direction.

This “when will they raise rates?” discussion brings to mind occasional posts that Mark has put up over the past two years that point to rising rates as a possible indicator that the bull market may be ending. For instance:

I’ve written a number of times that I don’t think this bull market will end until that monetary policy begins to tighten. And while the winding down of the Quantitative Easing programs could be interpreted as the beginning stages of that tightening, even after that stimulus ends, we’ll still have interest rates at nearly zero. So I think we have a ways to go yet before this bull is finished.

But as we’ve frequently pointed out, bear markets always follow bull markets and your long-term plan must take this into account—by setting your stock exposure commensurate with your season of life and investing temperament.

As Mark concluded this past May:

The next 18-24 months may or may not unfold the way I’ve described here. Our investment success isn’t reliant on making good predictions, and yours shouldn’t be either. That’s a horrible way to invest. But if you’re following SMI’s strategies and have an appropriate risk mix based on your season of life, you don’t need to worry about predictions. We think that offering an educated guess of what the future may hold can be helpful if it helps you stick with your plan during periods of market uncertainty and fear. But it’s no substitute for following the personal plan that we encourage all readers to create when they start investing according to SMI principles.

Austin Pryor

By Austin Pryor

Austin Pryor has three decades of experience advising investors, and is the founder of the Sound Mind Investing newsletter and website. Austin lives in Louisville, Kentucky, with Susie, his wife of 46 years. Two of his sons, Andrew and Matthew, work with him at Sound Mind Investing. A third son, Tre, is a RealtorŪ in the area.