Every day most investors listen to the advice of their brokers or advisers. Often the advice they receive is to move their funds from one mutual fund to another, based on the poor past performance of their current fund manager and the stellar performance of the recommended investment.
These recommendations are contrary to the SEC mandated disclaimer that, “Past performance is not an indication of future performance.” Curiously, the data indicates that past performance is an indicator of future performance, but not in way your broker believes it to be.
One study looked at the best performing 100 fund managers over a 12-year period from Jan. 1, 1999 to Dec. 31, 2010. Only about 13 percent of these rock stars were able to repeat their performance in the second year. In several years studied, none of the top 100 fund managers replicated their standing. Skill persists, but luck doesn’t. And it gets worse.
What if your broker was one of the most skilled advisers in the world, responsible for managing over $10 trillion in assets for pension plans, endowments, and foundations? Surely, with this level of expertise, he would be able to make decisions about switching assets from underperforming funds to outperforming ones. But that’s not always true.
In an exhaustive study, researchers looked at more than 80,000 investment decisions made by plan sponsors or their consultants. They found the funds to which assets were transferred generally underperformed. The plans would have been far better off if they just left the assets where they were and made no changes. In only two years of the 18-year period studied (1984 to 2007) did the decisions to move assets from one fund manager to another add value. The authors of the study estimate that over $170 billion of investment value was lost during this period.
It’s not surprising that another study found that public pension funds for the 50 biggest cities and counties are underfunded by $382 billion. Total unfunded liabilities for all municipal plans in the U.S. could be as much as $574 billion. The amount of assets in these plans gives them the ability to retain the best, most experienced investment advisers and consultants in the world. How have they fared so badly?
Just follow the money and you will find the answer. The big bucks are in selling an expertise that does not exist, and populating these plans with expensive, actively managed funds, where the fund manager attempts to beat a designated benchmark like the S&P 500 index. The non-existent expertise is the ability to time the markets and pick outperforming stocks. The pension plans are led to believe these advisers can successfully engage in tactical asset allocation, a fancy term for market timing. The fact that there is no data indicating that anyone has this ability is rarely considered. Instead, by confusing luck with skill, advisers who get it right for short periods of time tout their expertise, and ignore the fact that random chance would have produced the same results.
Ignoring this data is harmful to your wealth. You need to fundamentally change the way you invest by rejecting discredited notions of stock picking and market timing. Instead, you should invest in a globally diversified portfolio of low management fee index funds, passively managed funds, or exchange-traded funds, in an asset allocation suitable for you. Unlike the way you are currently investing, there are reams of data supporting this approach. I summarize this research in The Smartest Investment Book You’ll Ever Read.
Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.