You're Probably Not Going To Beat The Market

Business DayYour MoneyWorldU.S.N.Y. / RegionBusinessTechnologyScienceHealthSportsOpinionArtsStyleTravelJobsReal EstateAutosmodifyNavigationDisplay();/**//**//**/// if ((typeof adxpos_TopAd == "undefined") || (typeof adxads[adxpos_TopAd] == "undefined")) { if($("TopAd")) { $("TopAd").hide(); } } ///**/// if ((typeof adxpos_PushDown == "undefined") || (typeof adxads[adxpos_PushDown] == "undefined")) { if($("PushDown")) { $("PushDown").hide(); } } // April 9, 2012, 12:19 pmIt’s Probably Not Going to Be You Who Beats the Market By CARL RICHARDSCarl Richards

Carl Richards is a certified financial planner in Park City, Utah, and is the director of investor education at BAM Advisor Services. His book, “The Behavior Gap,” was published earlier this year. His sketches are archived here on the Bucks blog.

Growing up, we learned that two plus two equals four. We take comfort in numbers having a set value. So it's totally logical that when we look at the ticker tape of numbers scrolling across the television screen, we think that there must be some perfect formula for revealing the secret of investing.

Numbers don't lie, right?

But as this article about pension funds trying to improve their performance using alternative investments reminded me, we need to understand what we're up against when we start searching for an amazing, index-beating manager, fund or investment.

Turns out that finding the next Warren Buffett is not impossible. But it is highly improbable. Think I'm too pessimistic? Consider these three points carefully:

1. The data (not just me) shows the odds aren't in your favor.

As I discussed back in February, Standard & Poor's most recent Persistence Scorecard highlights just how difficult it is to identify consistent market outliers. For instance, ending in September, 2011, only 9.72 percent of all the large-cap mutual funds managed to be above average, every year, for five consecutive years.

2. If superior managers exist, how do you plan to find them beforehand?

So there are a few managers that have the ability to outperform the average, at least over five years. But how do you plan to identify them beforehand? And how confident are you that the formula you've set up will identify the superior manager for the next five years? What about the next couple of decades?

Any bragging from your friends (or their fund managers) about how well they did the last 10 years doesn't matter at all. What we need to know is who will do well for the next 10. The fact that some managers do indeed deliver  leads us to the false and very dangerous assumption that we can identify them beforehand.

But there is a large body of academic work looking at every variable in the hopes that we can find something that will have predictive value. Past performance, education, experience, or hair color — none of them help.

Turns out that the one variable that seems to have predictive value is cost. The more it costs you to own the fund, the lower your return will likely be. Makes sense. After that it seems to be a crap shoot. Again, not impossible, just improbable.

3. Streaks come to an end.

Managers are hot, until they're not (like Bill Miller). Some managers are great, but then they retire (like Peter Lynch). At some point, the streak will end. Do you know with certainty that your formula will predict that end date accurately?

Do you think anyone saw the downfall of Tiger Management? Introduced in 1980 with $8 million, the fund peaked in 1998 at $22 billion. Could your formula predict a few bad bets and the subsequent investor withdrawals? Two years later, Tiger was liquidated with only $6 billion in assets.

You do have an alternative. And in this instance, the math is in your favor.

I think of it like a game of golf. What if you could make par (a great golf score) every time you played? Many golfers I know would jump at the chance. In investing terms, making par is comparable to buying a low-cost index fund. You give up the chance of hitting a hole-in-one but avoid the very high likelihood of landing in the pond.

Maybe it feels un-American to do this and that if we work really hard, the numbers will swing in our favor. But do your research. Look at the evidence.

The reality is that for many of us, playing for par is going to be awesome. But if you insist on swinging for the hole, go into it with your eyes wide open, having evaluated every last bit of data.

 

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Carl Richards is a certified financial planner in Park City, Utah, and is the director of investor education at BAM Advisor Services. His book, “The Behavior Gap,” was published earlier this year. His sketches are archived here on the Bucks blog.

Growing up, we learned that two plus two equals four. We take comfort in numbers having a set value. So it's totally logical that when we look at the ticker tape of numbers scrolling across the television screen, we think that there must be some perfect formula for revealing the secret of investing.

Numbers don't lie, right?

But as this article about pension funds trying to improve their performance using alternative investments reminded me, we need to understand what we're up against when we start searching for an amazing, index-beating manager, fund or investment.

Turns out that finding the next Warren Buffett is not impossible. But it is highly improbable. Think I'm too pessimistic? Consider these three points carefully:

1. The data (not just me) shows the odds aren't in your favor.

As I discussed back in February, Standard & Poor's most recent Persistence Scorecard highlights just how difficult it is to identify consistent market outliers. For instance, ending in September, 2011, only 9.72 percent of all the large-cap mutual funds managed to be above average, every year, for five consecutive years.

2. If superior managers exist, how do you plan to find them beforehand?

So there are a few managers that have the ability to outperform the average, at least over five years. But how do you plan to identify them beforehand? And how confident are you that the formula you've set up will identify the superior manager for the next five years? What about the next couple of decades?

Any bragging from your friends (or their fund managers) about how well they did the last 10 years doesn't matter at all. What we need to know is who will do well for the next 10. The fact that some managers do indeed deliver  leads us to the false and very dangerous assumption that we can identify them beforehand.

But there is a large body of academic work looking at every variable in the hopes that we can find something that will have predictive value. Past performance, education, experience, or hair color — none of them help.

Turns out that the one variable that seems to have predictive value is cost. The more it costs you to own the fund, the lower your return will likely be. Makes sense. After that it seems to be a crap shoot. Again, not impossible, just improbable.

3. Streaks come to an end.

Managers are hot, until they're not (like Bill Miller). Some managers are great, but then they retire (like Peter Lynch). At some point, the streak will end. Do you know with certainty that your formula will predict that end date accurately?

Do you think anyone saw the downfall of Tiger Management? Introduced in 1980 with $8 million, the fund peaked in 1998 at $22 billion. Could your formula predict a few bad bets and the subsequent investor withdrawals? Two years later, Tiger was liquidated with only $6 billion in assets.

You do have an alternative. And in this instance, the math is in your favor.

I think of it like a game of golf. What if you could make par (a great golf score) every time you played? Many golfers I know would jump at the chance. In investing terms, making par is comparable to buying a low-cost index fund. You give up the chance of hitting a hole-in-one but avoid the very high likelihood of landing in the pond.

Maybe it feels un-American to do this and that if we work really hard, the numbers will swing in our favor. But do your research. Look at the evidence.

The reality is that for many of us, playing for par is going to be awesome. But if you insist on swinging for the hole, go into it with your eyes wide open, having evaluated every last bit of data.

 

Children often ask tough questions about money. In a series of posts this month the Bucks blog will discuss them one by one. We invite you to answer a few yourself or suggest new ones that your children have asked.

Paul Sullivan writes about the strategies that the wealthy use to manage their money and their overall well-being.

All of us need to take some time every so often to knock things off of our financial to-do list. To help, we've created a series of articles and an interactive checklist to get you started.

Increasing your savings by one more percentage point "“ or even better, another percentage point a year "“ can add up to big additional savings over time.

An interactive tool to estimate the future cost of higher education.

Compare the cost of renting and buying equivalent homes.

See how long it could take for your portfolio to return to its peak value.

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