A Warning About That Guy Who Is Beating the Market

We all want to beat our competitors. This includes beating the stock market and then bragging to our friends. What we are really doing is gambling and speculating with our investment dollars. One way to improve investing results is to stop this gambling, build a prudent portfolio, a globally diversified portfolio and rebalance. This improves results as well as reduces anxiety. Any time used to beat the market is time wasted.

Investment Conference
Investment Conference (Photo credit: Salmaan Taseer)

2) Skill versus luck If your conversations with “that guy” veer toward past performance, remember that you still need to determine if that mutual fund did well because of skill or luck. In other words, is the performance repeatable? And will it happen again once your money is in the fund?

Statistically, even if a fund beat the market average for 25 years we still can’t say with any degree of confidence it was because the manager was skillful versus lucky. Prof. Ken French at Dartmouth has already worked out these numbers. If you assume the fund beats the market by five percentage points per year, which is a huge number, and had volatility of 20 percent per year, you would still need 64 years of data before you could be confident the superior performance was because of something other than luck.

64 years!

The point is that finding skill in the world of mutual funds is almost impossible, and betting your retirement money on luck sounds like a bad idea to me.

3) Rear-view-mirror investing leads to accidents

Even though it seems logical, making investment decisions based on past performance doesn’t add up. In almost every other area — business, construction, medicine — past performance matters. But with investing, past performance tells us virtually nothing about future performance. At this point, it’s settled doctrine. The academics, regulatory agencies and most professionals agree: when it comes to investing, past performance has zero predictive value.

But for the sake of argument, let’s say there is some value in past performance. Most thoughtful people will not argue that it’s impossible for a mutual fund manager to outperform the market. The bigger question is this: How will you identify that manager in advance?

When you’re talking to “that guy,” be prepared to hear how much he thinks the past influences the future. Now you know better.

The Wall Street bullies want you to believe that they can predict the future. This is not investing it is gambling and speculating with your money. This is ok if that is your goal, however it is not a strategy to reach a long term goal.

Please comment or call to discuss how this affects you and your financial goals.

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