This post is a preview of WorthPointe’s e-book Evidence-Based Investing: Separating Fact From Fiction, written by Certified Financial Planner™ Scott O’Brien. In Evidence-Based Investing, Scott discusses the myths and misinformation that most often slow or halt our financial goals. Get your complimentary copy of Evidence-Based Investing here.
Just because a certain money manager or mutual fund beats the market for a few years, you shouldn’t jump to the conclusion that it was due to being smarter or more skilled. Most likely, it was dumb luck.
The odds of beating a benchmark in any one year are 50%. Then the odds of beating the benchmark three years in a row is the same as flipping a coin and getting heads three times in a row — an occurrence that is expected 12% of the time.
So with thousands of fund managers in the investment field, shouldn’t we expect 12% of them to beat their benchmark for three years in a row simply by random chance? Since this is statistically likely, why would you place any predictive value on the likelihood that the managers in the top 12% will continue to outperform? You shouldn’t.
Mark Carhart did a study that tracked fund performances back to 1962. He concluded that performers in the top 10 percent in any one year are more likely to fall to the bottom 10 percent than to repeat in the top 10 percent.
CNBC often trots out the latest manager who has beaten the market averages, anoints them as the latest flavor of the month and implies they are someone we should listen to for investment advice for the next 10 minutes.
Since there is no evidence of persistency of performance in fund returns beyond what could be randomly expected, a logical person must not attribute a particular fund’s outperformance to skill instead of luck.
Read the rest in Evidence-Based Investing. Get Your Complete Copy of the Book Now.
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