Friday, September 14, 2007

Previous Performance is not an indicator of Future Results

Have you ever noticed in small print at the end of every mutual fund commercial or magazine layout they say "Previous performance is not an indicator of future results."? Ever wonder why? While they may be legally bound to do so, there is also quite a bit of mathematical truth to that statement. Let's take one of my favorite examples, offered in Larry Swedroe's "Rational Investing in Irrational Times" book. (A great read, by the way.)

Imagine giving a room full of 1000 kids (or adults for that matter) a coin and telling them to flip it and try to get heads. Half of them would get it right. Taking the remaining 500, 250 could repeat their performance -- getting heads twice in a row. Continuing down this path, half of the kids would flip heads each time taking our winners down to 125, 62, 31, 16, 8, 4, 2 and eventually the final winner on the 10th flip. So did the kid who flipped heads 10 times in a row demonstrate skill at flipping heads? No, his odds of flipping heads on his next flip are still 50/50, just like everyone else. He just illustrated a statistical fact. That random acts produce a bell shaped curve. A very small percentage of kids flipped almost all tails, and a very small percentage flipped almost all heads, but the vast majority were somewhere in the middle. The problem is that at the beginning of the game, there would have been no way to identify the "genius" with the head-flipping "talent."

So while I agree that some investors have more skill and prowess than others, scores of academic studies have shown that chasing the "hot hand" on Wall Street is an unwinnable game for multiple reasons, but here are the two biggest:

1. Previous performance was enhanced by chance, and not purely a result of skill.

2. As more money flows in due to success, the manager must find more and more opportunities. The more money the fund manages, the less likely they will be to beat their benchmark.

All of that to say that you really should pay attention to the mutual funds when they say "Previous performance is not an indicator of future results." It's quite true.

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