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I’d rather try my luck in Vegas

January 24, 2012 - 4 comments

Truth be told, I’m not much of a gambler, but the allure of the bright lights, ringing bells, and the possibility of winning it big tugs at my better judgment. I’m particular fond of the game roulette. I normally place single “inside bets,” meaning that I would try to select the exact number of the pocket that the ball will land in (out of 38 numbers…at least in the American version). By doing this, I effectively have a 1 in 38 chance of choosing the correct number and winning the game (not the best odds, I assure you).

A 1999 study by John Bogle showed similar odds of success. He compared the returns of 355 U.S. equity mutual funds over the past 30 years and found that only 9 funds managed to outperform the market by at least 1% (he considered these to be “true winners”). This would imply that as an investor in 1970, you would have had a 1 in 39 chance of selecting one of the winning mutual funds – slightly worse than your odds at selecting the exact number on a single bet in the game of roulette.

Just as selecting the exact number in roulette isn’t a prudent investment strategy, neither is attempting to select an outperforming fund manager in advance. The odds are not in your favour, so why bother playing? Instead, it may be more appropriate to invest your retirement savings in low-cost, passively managed ETFs and mutual funds, and leave the gambling for your next trip to the casino.

By: Justin Bender with 4 comments.
Filed under: Active vs. Passive
  02/02/2012 10:34:36 AM
Justin Bender
Hi Peter – excellent point about the cost of active management being the main reason for their consistent underperformance. William Sharpe makes this same observation in his paper, “The Arithmetic of Active Management.” For a taxable investor, the higher portfolio turnover of an active fund (relative to a passive one) would most likely erode even more of their capital through higher taxes.

I see many investors who hold a single security of a former employer – I don’t have an issue with this, as long as it is a small allocation of their overall portfolio (perhaps no higher than 5%).

As for the REIT issue, again, I don’t see this as a problem for a large investor, but for a smaller one, it could result in a greater amount of trades (especially when rebalancing) – an allocation to XRE or ZRE may be more appropriate for the average investor (and only add a few basis points to the overall MER).

All the best,

  01/02/2012 4:10:57 PM
Peter Chung
Hi Justin,

Great post, bang on,... I think the difference between the active managers and the markets is cost of the active managers (at least on pre tax basis and the performance would usually be worse on after tax basis).

I like to run on and add a couple of points. I go to the casinos too, its gaming, its fun. My portfolio has got some of this fun too (ie I own a stock in an industry where I worked and know the executives, I've held and believe in a specific company for a very long time (or it could be a mutual fund, my past example was Alan Jacobs with Sceptre Equity)..... I think this fills a human need and I like to look at it in the context of ones investment portfolio and the risk impact.

I also think in some cases there are better alternatives. For example, as oppose to buying the Canadian ETF XRE for REITs. I own several of the REITs that reflect about 60% of XRE or this market and avoid XRE or mutual funds that all have high cost relative to the expected return.

Thank you,

  26/01/2012 9:20:11 AM
Justin Bender
Hi James – thank you for taking the time to post. The article is not urging speculation...actually, quite the opposite. If you know of any research that supports your theory about your odds for an astute investor increasing to 1 in 3 or 1 in 2 for picking a winning active mutual fund manager in advance over 30 years, I’d be happy to post the link for you. Another issue would be that even if you originally picked the winning manager but they underperformed for the first few years, you may be tempted to switch to the manager that had been outperforming for a few years (research shows this is usually not a wise approach either).
  26/01/2012 8:21:51 AM
James McDowell
There are a number of assumptions not identified in the article. The assumption is the investor doesn't know anything about any fund, and continues not to know anything about any fund or the market in general throughout the 39 years.

While that may be true in many cases, and while the knowledgeable investor still may have a great deal of difficulty in getting the odds up to 1 in 3 or 1 in 2, they may be better than Vegas, I think.

I'm always suspicious of too broad a brush, whatever picture is being painted, including pictures urging speculation, particularly where financial advice is being provided.

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