“Well, I lost another 500 bucks today!”
That was the greeting we received from our youngest son upon his arriving home after football practice last week. My wife and I looked at each other a bit puzzled then he quickly explained that his hypothetical portfolio of individual stocks in his high school business class were tanking. It seemed that Apple and Nike were not performing as he was sure they would after he snatched them up early in the exercise. Unbeknownst to him, I said a silent prayer of thanksgiving that his experience was going badly. There are many individual investors today who did well in that silly 10th grade contest and are now playing the losers game of stock picking/timing the market with real money. Our son will now hopefully never be cursed with this fate.
Aside from lamenting that this exercise goes on in virtually every school across the country, (I remember doing it in the late 1970s in Economics class – do you?), our son’s experience allowed me to teach an important investing lesson.
Do you know how unlikely it is that you can choose mutual fund managers who can pick stocks and time the market successfully? That is to say choose active managers that can consistently beat their comparative indexes. The Center for Research in Security Prices at the University of Chicago has done the research. They looked at 16 categories or asset classes of equity funds over the last 10 years ending December 31, 2011. The research showed that the odds of making a selection of a “star” manager who could beat their index was worse than a coin flip in each case. The most likely opportunity to do so was in the Small Cap Value asset class in which 46% of active managers beat their index.
After that, Small Cap Core at 32% came in second. In the Large Cap Core asset class investors had only a 5% chance of finding a guru who could top the market with his/her “expertise.” I am not a math genius – nor the son of one – but I can tell you that if the prospect for finding one manager in one asset class is this poor, then doing the mathematical odds of finding two or three or sixteen gurus is almost incalculable. If you take just Small Cap Value and Small Cap Core, the odds are 0.46 x 0.32 = .147 or about a 15% chance that you can find those two. Add Large Cap Core at 5% and you are now reduces your chance to a 1 in 135 chance of finding three gurus and so on. Even supposing you could – would you be able to do it the next year? By the way, the same manager rarely repeats the nice performance two or more years in a row. (For those who are curious – the odds of successfully finding managers in all 16 asset classes that beat their index benchmarks in the affore-mention study is approximately 1 in 10 trillion. (No kidding).