THE BLOG
02/07/2012 07:29 pm ET Updated Apr 08, 2012

Your Broker Has No Clue

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.