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Investing for Beginners: Playing the Odds Smartly

Stupid

Each day, we are bombarded by storylines from the financial media about daily market trends and events that may yield a clue on where the next investment opportunity, or threat, may be.  The sensationalism is hard to ignore, to the point where we can feel that not responding to these insights may make us feel as though we are missing out on the next great investment opportunity.

Smart investors know better.

You see, there are 2 primary genres of investing – active investment and passive, indexed investing.  Active investors are continually scanning the investment landscape for attractive investment opportunities with the hope that they can outperform a benchmark (an index the reflects the sector and risk profile that is representative of the portfolio).  Passive indexed investors simply invest in the benchmark, avoiding the fees and risks of the investment selection process associated with active investing.

So, which strategy is better?  The smart investor looks for relevant data to answer this question – so, here are nine facts that should make it quite clear how to invest smartly.

Investing for Beginners Fact #1:  Investment Selection Doesn’t Explain Returns

If active investing is the better strategy, then we would expect that the skill of selecting each investment would explain a significant portion of the returns on actively managed funds.  However, a study conducted by Gary Brinson, Brian Singer, and Gilbert Beebower on professionally managed investment portfolios found that asset allocation (i.e. how  the portfolio is allocated across broad asset classes such as stocks, bonds, and cash) explained 91.50% of all investment returns with the remaining 8.50% explained by security selection (i.e. the specific stocks and bonds purchased within each asset class) and strategic reallocation.

So, investment selection has very little to do with performance while the broader decision of asset allocation, which could easily be accomplished through indexed funds, explained close to all of the performance.

Investing for Beginners Fact #2: Fund Managers Can’t Consistently Outperform Their Benchmarks

Typically, indexed funds tend to outperform 60% to 80% of their active fund counterparts over a given time period.  While this reflects favorably on indexed funds, a natural question to ask is “what about the 20% to 40% of active funds that outperform indexed funds?”  Are these funds better alternatives to indexed funds?

One way to assess this is to see whether funds that outperform their benchmark index can do so consistently over a longer time period.  Barclay’s performed such a study, looking at what percentage of funds could outperform their benchmark over 1 year, 2 consecutive years, and 3 consecutive years, and comparing to the probability of flipping a coin and getting a “heads” on 1, 2, and 3 consecutive trials.  If the outperformance results are similar to the coin flip results, this would imply that consistent outperformance is not distinguishable from pure random chance.

Here is what they found:

So, as you can see, the ability of a fund manager to outperform a benchmark appears to be largely due to random chance, not skill.

Investing for Beginners Fact #3:  Markets Outperform Average Actively Managed Fund

Another insight from the chart appearing just above that should not be lost is even after just one year, less than 50% of actively managed fund beat their benchmark.  In another analysis, Zvi Bodie, Alex Kane, and Alan Marcus in their textbook “Investments” note that the Wilshire 5000 index outperformed the average professionally managed fund in 21 out of 37 years from 1971 through 2007, and was on average 1% higher.

Investing for Beginners Fact #4:  Experts Can’t Predict Good Funds

If active investing held promise, then it would be logical to assume that  experts should be able to study the performance of fund managers and distinguish between those that are likely to continue to be successful from those that will not.  If not, then it would be pointless to try and find a good actively managed fund.  Right?

Well, professor Matthew Morey of Pace University studied how well Morningstar and Value Line’s ratings of mutual funds predicted future performance.  The results – the mutual funds with the higher ratings did  not perform noticeably better than middle of the road ranked funds.  In fact, recent analysis performed by Morningstar indicates that expense ratios are a better predictor of future fund performance than their own ratings – the lower the expense ratio, the more likely the fund is to outperform others.

So, if the experts can’t distinguish between actively managed funds that are likely to perform well from an average actively managed fund, how are we?

Concluding Thoughts

These results should not be all that surprising, and in fact quite intuitive – if you add all investors together, you get the entire market.  Therefore, 50% of investors will always under-perform the market, and the other 50% will outperform the market.  Said slightly differently, every trade is going to have one winner and one loser.  Factor in research and trading costs and the inability to sustain above-average performance, and it becomes rather clear that passive indexed strategies, although boring and lacking sex appeal, is the best way to play against the house.

Posted by

John Bevacqua on April 11, 2012

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Investing

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