The Great Conspiracy

by: J. Patrick Collins, CFP® , EA

There is a massive conspiracy that has been perpetuated for decades amongst the investing public.  It runs so far and so deep that I would imagine that almost everyone has bought into it at some level.  No, this isn’t the sequel for the next Matrix movie; it has to do with your investments.

Billions of dollars in fees are collected every year by mutual fund companies and brokerage firms for the active management of your money amongst stocks and bonds.  The lie that you have been told is that those mutual fund managers can outperform their benchmark index, and that is worth the fee you are paying them.  Unfortunately, the vast amounts of research and academic studies have shown two simple truths:  First, 75 percent of all active managers fail to outperform their benchmark index any given year.  Second, there is no way to determine which active managers will be amongst the 25 percent that outperform in the upcoming year (i.e. past performance has no correlation to future results).  Before we get into the reasoning behind this phenomenon, let’s start with some background:

Passive management refers to the buy-and-hold approach of owning an entire asset class in order to obtain market returns, while active management is the art of stock-picking and market timing.  For years you have seen mutual fund companies, brokerage firms, and other investment professionals tout their historical track record of out-performance.  By understanding a hypothesis that has driven our economic system for hundreds of years, it will help you understand how the market works and why it is pointless to try to beat it.

The Efficient Market Hypothesis states that prices are always fair and quickly reflect all public information known.  This theory is not new, it is what capitalism is based upon and what Adam Smith, the great economist, referred to as the “Invisible Hand”.  His research found that free markets work and countries that adopted this approach thrived, while those which attempted to manipulate price and or social status (socialism, communism) failed.  So how does this relate to investments?  If the price of a stock is always fair and will constantly be adjusted to reflect all public information, there are never “undervalued” stocks.  If this is true, it is futile to engage in stock picking or market timing. 

This hypothesis shatters the myth that stock pickers have some innate ability to pick stocks or time the market.  In fact, if prices are always fair, the relative performance of any portfolio of stocks will be based entirely on luck.  Can that be true?  What about managers like Peter Lynch and Warren Buffet who have had decades of successful performance?  To explain, I’ll use an analogy to display the randomness of returns.

On January 1st we will select 10,000 people to compete in a coin flipping contest.  The contest is simple:  the group will flip their coin once a year, and to stay in the contest, you must flip heads.  So, on January 1st the group meets and each participant flips their respective coin.  As you might think based on the laws of probability, five thousand participants are immediately eliminated the first day, while the others need to wait another year to find out their fate.  The next January the remaining participants reconvene and flip their coin to see who will be purged from the competition.  This contest continues each year, and by the tenth year, there would only be 9 participants of the original 10,000 still competing.  After 10 consecutive years of flipping heads, many of these participants will believe they have developed a flipping method that insures that heads will always come up.  Others will have written books on how they have become experts at coin flipping.  The media would interview these remaining contestants, praising them for their coin flipping abilities.  Sound funny?  This is exactly what happens in the investment industry.  Managers like Warren Buffet, Peter Lynch, and Bill Miller are commended for their outstanding gift of stock analysis while the simple truth is, based on the laws of probability, when reviewing a large group of investment managers, there will always be a small group that seems to defy the odds and outperform the herd of other managers.  Unfortunately, studies continue to show that, like the coin flippers, their out-performance in the past, will have no bearing on the future.

Rather than spending time trying to pick a manager that will outperform (which we now know is futile), investors should seek council with the most important factor in the performance of their investments:  how they are allocated.  We’ll talk about this topic in an upcoming issue.

The information in this article is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, and does not purport to be complete and is not intended as the primary basis for financial planning or investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.