What Foolish Investors Believe

In their 1978 album, Minute By Minute, the Doobie Brothers tell the tale of a man who is self-deceived, believing a lie of his own fabrication. Somehow, this poor sap has convinced himself that he is a Casanova, the apple of some woman’s eye, when in fact he has never been so much as a blip on her radar. This pathetic chap just doesn’t get the facts. As one anonymous person quipped, “What seems to be is always better than nothing.” Unfortunately, this guy has bought into this ethos of ignorance and prefers his fantasy to the sobering reality that, if properly understood, could set him free to move on with his life.

This fictitious character’s predicament is not much different from what many retirement investors face. In love with the Wall Street fantasy of trouncing the markets through laser beam equity selection, many investors prefer to see themselves as a type of Warren Buffett—glasses slung low into the bridge of their nose, astutely gazing past today’s Journal while processing terabytes of random data with super-computing accuracy to distill the investment insight of the day.

The unfortunate fact, however, is that research unequivocally demonstrates that only a tiny percentage of professional money managers display such oracular talents. For those who value facts over fantasy, the fulcrum about which all investment activity should turn is that the overwhelming majority of active money managers do not beat the market.

Research by CXO Advisory Group LLC has revealed that stock market gurus have a forecasting accuracy rate of 47.5 percent in any given year. While you would do better flipping a coin, a further look at the stats is even more interesting. By extending the investment time horizon to five years, only 1 in 3 active managers beat their index. For the betting man, these odds quickly become unacceptable.

What if you tried to game the system and bought only the top-performing actively managed funds in any given year as the Morningstar systems seem to suggest? Within five years, 20 percent of these top-performing funds are closed due to poor performance, with 83 percent of the total group underperforming the index. Wow!

These facts, however, relate to one fund in one asset class. What happens if we compare active management to a real-world situation where your time horizon is 10 years out and you are investing across six asset classes or more? What then are your odds of beating the market? Research by numerous sources puts this likelihood below five percentage points.

As one famous money manager, Bill Gross of PIMCO, bravely stated, “The industry as a whole cannot outperform the market because they are the market, and long-term statistics revealing negative alpha for the class of active managers confirms it. Yet, what a price investors are willing to pay!”

What then does a fool believe? Amongst other things, that he can do what professional managers cannot—beat the market. For those of us who prefer reality, low-cost indexing, asset allocation, and driving down all unnecessary fees are the game of the day. Sure, we too enjoy reading our daily Journal, but we have been schooled by the facts and are better for it.