Your Money
Heads or Tails?
Either Way, You Might Beat a Stock Picker
JULY
26, 2014
Imagine a world where investors in the stock market have no skill
whatsoever. The investors themselves don’t understand this, however,
and many truly believe that they are good at what they do.
But in
this thought experiment, there’s no doubt about the underlying reasons
for fund managers’ success: When they turn in an outstanding
performance, it’s just a matter of dumb luck.
What
would stock fund managers’ performance numbers look like in such a
universe? Very much like the world we live in now, but with an
important difference: Over the last five years, actively managed stock
mutual funds have performed even worse than would have been
predicted if the fund managers were flipping coins instead of picking
stocks.
The
real-world statistics to which I’m referring were contained in a
recent S.&P. Dow Jones Indices study that I summarized in
last week’s column.
But as many astute readers observed in emails, tweets and phone calls,
I didn’t say how mutual funds would have fared if their performance
had been a matter of pure chance — a random draw, as statisticians
sometimes call it.
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Credit Minh Uong/The New York Times |
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“The
results were actually very close to what you’d find in a random draw —
or a series of coin flips, except they were a little bit worse,”
William D. Nordhaus,
a Yale economics professor, said in a phone conversation. The
empirical data supports the inference that it’s wise to use passively
managed index funds for the core of most people’s investment
portfolios, he said, but it doesn’t rule out the possibility that some
investors excelled for reasons other than dumb luck. In the real
world, he said, it’s possible that some rare individuals may actually
possess exceptional investment talent.
Briefly put, the results of the S.&.P. study,
“Does Past Performance Matter? The Persistence Scorecard,”
were bleak enough on their own. They showed that very few mutual funds
were able to consistently outperform their peers, and that those that
did so in one given year were likely to be poor performers five years
later.
In fact, only 2 out of 2,862 broad domestic stock funds were able to
outperform their peers consistently over five years, according to one
measure: performance in the top quartile of funds over five
consecutive 12-month periods ended in March 2014. That translates to
just 0.07 percent of the funds, which means that more than 99.9
percent of funds fell short of that feat.
That’s
an unimpressive performance, to be sure. And if you compare it with a
series of coin flips — a series of random choices — it looks even
worse.
For
those interested, this is how the coin-flipping comparison works: You
toss the coin. Is it heads or tails? There’s a 50 percent chance of
either outcome. Let’s say the coin lands on heads. If you flip it
again, the probability that the coin will land on heads the second
time is also 50 percent. Because there are four possible outcomes for
the two flips, there’s a one-in-four, or 25 percent, chance that your
coin will land on heads twice in a row.
Repeat
those double flips five times and you’ll find the probability of a
mutual fund ending up in the top quartile five times in a row through
chance: 0.098 percent. (We’re flipping the coin twice for each year of
mutual fund performance.) That’s a bigger probability than the 0.07
percent scored by the actual funds. This means that if mutual fund
managers had just flipped coins, roughly three of them — not two —
would have been expected to end up in the top quartile for five years
in a row.
Still,
the dismal results of the real-world fund managers were very close to
what Burton G. Malkiel, the Princeton finance professor, once
described as “a random walk.”
“Taken
to its logical extreme, it means that a blindfolded monkey throwing
darts at a newspaper’s financial pages could select a portfolio that
would do just as well as one carefully selected by the experts,” he
wrote in his guide to investing, “A
Random Walk Down Wall Street.”
As a
group, managers who ran the 2,862 funds examined by S.&P. Dow Jones
Indices didn’t do as well as a blindfolded monkey. The hypothetical
monkey, or a serial coin flipper, beat them in several other tests,
too.
What
should we make of this?
Paul
Samuelson, the late Nobel laureate from M.I.T., with whom Professor
Nordhaus collaborated on the textbook “Economics,” wrote several
influential academic papers that dealt with the issue. In “Challenge
to Judgment,” a 1974 paper that
inspired John C. Bogle
to create the first index fund at Vanguard, Professor Samuelson said
that deep, liquid markets like the stock market were efficient enough
to make short-term investing very much like a random draw. Index funds
would be a better choice for most people, he said.
Yet
Mr. Samuelson also believed that some investors were truly talented —
even if they faced steep odds in beating the market consistently.
“Paul
thought that Warren Buffett was a true genius,” Professor Nordhaus
recalled. Indeed, in a 1989 paper, Professor Samuelson pointed to Mr.
Buffett as an outlier, an investor who appeared to have “flair.” Yet
he said that even Mr. Buffett could be expected to have difficulty
keeping ahead of the competition in the future. One reason was that if
anyone starts to beat the market in a noticeable way, imitators will
eliminate his edge.
“The
market shows some efficiency in recognizing the occasional genius,”
Mr. Samuelson wrote. And, as it’s turned out, Mr. Buffett’s recent
performance has been quite ordinary, as
a study by Salil Mehta,
an independent statistician, found earlier this year.
Mr.
Mehta was also among those who emailed and blogged about the S.&P.
findings last week. And he said in his blog that the exercise doesn’t
show “that the cause of the selected managers’ success is due to luck
as opposed to skill.” But it does illustrate how rare it is for funds
to outperform for any reason.
As
Keith Loggie, senior director of global research and design at S.&P.
Dow Jones Indices, said last week: “It’s quite possible that a number
of fund managers have real skill. A few funds in the study did very
well, and you’d think there was some skill involved in that level of
performance. We’re not assuming that it’s pure luck. We don’t know
what it is. But what the study did show is that the chance of any
outperformance persisting for any extended period is very low. And
it’s extremely unlikely that you can pick an outperformer based on
past performance.”
It
wouldn’t be unreasonable to draw another conclusion. These findings
may suggest that rather than spending a lot of time and money picking
stocks or stock fund managers based simply on past performance, you
might be better off just flipping a coin. And that implies investing
in low-cost, diversified index funds.
A version of this article appears in print on July 27, 2014, on page
BU3 of the New York edition with the headline: Heads or Tails? Either
Way, You Might Beat a Stock Picker.
© 2015 The
New York Times Company