I am fascinated by the way most people invest, because it is demonstrably wrong. Here's how you probably pick your mutual funds.
Your broker calls and tells you about a mutual fund he believes is right for your portfolio. The pitch usually involves a discussion of the stellar past performance of the fund. He encourages you to sell funds that have underperformed and buy ones with better performance. The process repeats endlessly. You fall for it every time. Does this make sense?
In a thoughtful blog, Brad Steiman, a vice president of Dimensional Fund Advisors, discusses the many problems with this approach.
Recent performance can be misleading
Steiman notes that a few years of outperformance may not be indicative of skill. The fund manager could just be lucky. For example, a fund that had an average "alpha" (positive return above its benchmark) and a standard deviation (measurement of volatility) of 6%, would require a track record of 36 years before you could be 95% certain the fund manager was skillful and not just lucky. A 6% standard deviation of alpha is representative in the Morningstar data of actively managed US equity mutual funds.
Just for fun, ask your broker this question the next time he recommends a mutual fund: How long a track record would I need in order to determine if the performance of the fund manager was evidence of skill? He won't know the answer, but the blank look will be worth your effort.
Finding the needle in the haystack may not be enough
Let's assume you have a terrific broker who has a modest understanding of statistics. The broker tells you he has found a fund manager with a long enough track record to indicate skill and not luck. Should you buy that fund?
Probably not. According to Steiman, one out of 40 managers is expected to meet this criteria based on luck. He concludes that even with this impressive track record, "[T]here is still a 2.5% probability the outperformance was due to good luck, and the true alpha of the manager is zero."
The Fund Manager's Skill May Not Persist
It gets worse. Even with a statistically impressive past performance, Steiman notes that "...winners do not continue to win, and even when there is alpha in the extremes, it does not persist."
You can't expect your broker to understand how to evaluate statistical data. They are salesmen (and women). But you can -- and should -- educate yourself with a basic understanding of how to determine whether the next "hot" fund manager shows evidence of skill or is the latest false prophet hyped by the financial media and the securities industry.
I agree with Steiman. You need to get off "the manager selection merry-go round".
Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.
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Its a remarkably small number.
Most of the time they just tell you..."You are seriously under-insured"
Guys like Jon Corzine.
"there is great opportunity and huge potential in Euro-zone soverign debt"
Joe Kernan looking at him like he's got two heads.
but.........said nothing
Plenty of lower cost options and info out there, though. If Gen Y can figure out a video game, they can figure out a mutual fund statement.
Most investors will tell you to take into consideration your investment timeline. Investing long term you want growth stocks in growth economies so you want a growth fund probably a no load growth fund with exposure to the BRIC economies.. As you get closer to retirement, you begin moving from growth to liquidity, from stocks to bonds, or stocks that pay hefty dividends like oil stocks. If you can figure out how the demographics will affect the economy you can get ahead of the curve.
For most Americans facing retirement, their best investment will be electing representatives who will defend/increase their social security benefits. Unlike the markets, it is a sure thing.
Part of the inherent problem of "the stock market" is that it IS "a market," and it has "owners" and therefore "owner's priorities" that have nothing in particular to do with those of the corporations whose shares are being bought and sold. Wall Street's most profitable product is probably "the IPO." Beyond that, it's the one that does the biggest =volume= because =volume= (not share price) is what drives the income stream of the owners of the =market.= Many mutual funds take the same basic approach: they want you to make trades. They want you to tinker, because every time you do that, another dime drops into their bucket.
A friend of mine collects antique mechanical slot-machines. When playing one, using a bucket of red-painted quarters he cheerfully provided, I noticed that every now and then the quarter went "plunk" instead of "plink." He opened the machine to reveal that every twenty-fifth quarter dropped into a separate jar. "This is the house's take," he explained.
1. brokers get paid to invest the money - they don't get paid to have money on the sidelines. That is a conflict of interest.
2. the markets have turned into a big wealth extraction scheme - wall street and HFT's exist to take some of your invested money. People don't trust the market for very good reasons.
2. most brokers don't have a clue when it comes to the big picture of investing. They chase momentum and headlines. They have very few original thoughts of their own.
All in all, until the Fed ends the madness of driving people into risk and raises interest rates back to more appropriate levels, people will lose money in the rigged investment world.
I can already hear the screams as Facebook becomes a penny-stock. Some people never learn.