Wednesday, April 6, 2011

A sixth way that the WSJ missed

In the April 4 edition of the Wall Street Journal, the article "Numbers You Can't Count On" lays out five reasons that a mutual fund's impressive record may tell you less than you think.  With the very first reason, the article buys into the mythology that some portfolio managers will actually be able to beat the market on a consistent basis over an extended period of time.

So consider a sixth way that the past performance can be misleading:

Assume that none of these five reasons apply.  Let's say the heroic fund manager hasn't changed.  The fund is the same nimble size as always.  It is compared against a reasonable set of peers (whatever that means).  It doesn't bounce among categories and it has maintained a consistent strategy.

If the fund is actively managed and has above-average returns, those above-average returns are almost certainly due to luck.  If half the funds between the market in any given year, then some lucky portfolio manager (we would expect one out of every 32) will beat the market five years in a row.  And one out of 64 will beat the market six years in a row.  But since some of those 64 that we started with 6 years ago will have failed by now or merged with another fund, at any given point in time you'll have more than one in 64 funds boasting that they have beat the market 6 years in a row.  That doesn't mean they are any likelier than chance to beat the market next year.

Certainly the Wall Street Journal reporters are smart folks, and they probably know this.  But active investors who have faith in their superior abilities aren't likely to be interested in reading that message.

From Innovation Bootcamp

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