In my prior post, I wrote about why it is so difficult to predict the future of any publicly traded investment, whether an asset class like the U.S. stock market or an individual investment like Apple stock.  The next step is to show how this is borne out, in terms of how difficult it is to beat the market, and why you should be leery of anyone who claims to be able to do so.

Eugene Fama is a Nobel Prize winning professor at the University of Chicago.  He and his good buddy Kenneth French at Dartmouth collaborated on a paper titled Luck versus Skill.  In that paper, Fama and French looked at stock mutual fund performance over twenty-three years. They then adjusted that performance for the excess risk that the mutual funds took, such as by having more stock in smaller companies or in companies with lower price-to-book ratios.  They found that in the aggregate, mutual funds under-perform the market by an amount roughly equal to the fees that they charge their investors.

Of course, some mutual funds performed very well during that time, whereas others performed very poorly when compared to the overall market.  For the mutual funds that performed very well, even on a risk-adjusted basis, how much of that performance is due to skill, and how much of it is due to luck?  Fama and French determined that only the top three percent of mutual funds outperformed what would be expected on a risk-adjusted basis after expenses.  That top three percent, however, barely beat a passive, low-cost index fund. In other words, the success of that top three percent is not so clearly due to skill that we as investors should put any faith in those mutual funds.

What can we learn from this?  First, it is very hard to beat the market, especially when accounting for expenses and risk.  Second, even if someone beats the market, potentially for many years in a row, it is more likely due to luck than skill.  This is borne out by how often the top performing mutual funds one year perform poorly the next year.  Third, low-cost index funds are more likely to give you the best performance in the long-run because they 1) keep expenses minimal; and 2) remove the possibility of having an unskilled or unlucky mutual fund.

-Richard

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