Wrong Questions & Wrong Answers

Recent research has (once again) shed light on the age-old quest of seeking superior investment performance (hat tip to our colleague Larry Swedroe). While the academic paper is aimed at institutional investors, the findings apply equally to all investors.

The paper’s title “False Discoveries in Mutual Fund Performance by Barras,Scaillet, and Wermers tells the tale. Many investors, aiming to outperform the broad markets are , in reality, asking the wrong question. Instead of asking “how can we beat the market” the correct question would be “how can we accrue what the market freely provides?” As is often the case, if you ask the wrong question then you get the wrong answer .

This new research looks at the role of luck (chance) in achieving what is known as “alpha” (positive risk-adjusted performance). Simply put the paper looks at over 2000 mutual funds and then puts them into 3 broad categories: those that underperform (unskilled); those that roughly match the market (zero alpha); and those that beat the market (skilled).

The research found that almost 24% of the fund managers were unskilled; 75% matched the market ;and about 1% outperformed. The number that exhibited “skill” is close to what would be expected by luck/chance. As Larry Swedroe puts it “why do people keep playing a game where only 1% of the players win and 24% lose?” That indeed is the right question.