Does this sound like anybody you know?

• 401(k) at current job: 5 mutual funds
• 401(k) still with previous employer: 4 mutual funds
• IRA: 3 mutual funds, handful of stocks
• spouse’s 401(k) at current job: 5 mutual funds
• Spouse’s IRA: 4 mutual funds, another handful of stocks

Grand total: Somewhere from 15-25 different mutual funds and a seemingly random assortment of stocks.

What’s the Problem?

What this person has amassed is the equivalent of an index fund, with the noteworthy difference that the fees being paid are the higher fees that come with actively managed funds. (That is, this person is probably paying 1.5%-2.5% in fees per year rather than 0.2% per year.)

People invest in actively-managed funds with the hope that the fund manager(s) can outperform the market. While there’s less than a 50% probability that a fund manager can beat the market, it’s certainly not impossible. The problem, however, is that once you own more and more actively-managed funds, the chance of them–in total–beating the market becomes more and more slim.

Imagine this scenario:

• You’re flipping a coin.
• Heads means your fund beats the market. Tails means your fund underperforms the market.
• However, this coin is a trick coin, and it comes up tails 55% of the time.

Of course, if you only have to flip the coin once per year, your chance of beating the market is 45%. Not great, but not awful. But if you have to flip the coin 15 times each year (ie, you own 15 actively-managed funds), your chance of coming out ahead is significantly lower than 45%.

Or to look at it without using hypothetical coin flip scenarios, just consider this: The way that a fund manager hopes to outperform the market is by over or underweighting certain stocks (or certain sectors or asset classes) when they feel it’s advantageous.

Unfortunately, the more funds you own, the more likely it is that some of the managers are taking completely opposite strategies, thereby cancelling out any potential advantage to be gained, but still leaving you with the higher cost.

We all know that choosing a mutual fund based entirely on past performance is a pretty poor idea. Well, we “know” it, but that apparently doesn’t stop us from doing it anyway. After all, the reason the mutual fund companies spend so much time and money promoting the results from their best-performing funds is that it brings in money. Lots of it.

And, if I’m honest with myself, I have to say that I do it as well (on some level at least). For example, if a fund had:

• An investment strategy that was 100% in-line with my own,
• A team of managers with plenty of experience,
• Low costs, and
• A long track record of poor results…

…would I be reluctant to invest in it? You bet I would.

In fact, I can’t even imagine investing in a fund without looking at its results.

So, given that most of us really do make investment decisions based (at least in part) upon past results, my question is this:

Why not look at results from relevant time periods?

Everywhere we look, we see 1-year, 3-year, 5-year, and 10-year records of performance. If we’re looking at equity funds, the only one of those that matters at all is the 10-year record. And what about the 20-year and the 30-year records? I’d like to see those too, please. Doesn’t it make sense to look at periods of time that are roughly equal to the amount of time we foresee holding the fund?

In other words, if we’re going to hold a fund for 20 years, how about looking at how it’s done over 20-year periods?

And if we’re going to use past performance, why don’t we at least broaden our data set? Rather than just look at the last 10-year period, how about looking at all the 10-year periods since the fund has been around? Let’s see the best, worst, mean, median, etc.

I’m far from convinced that we can use past performance to accurately select funds that are likely to perform highly. But if we’re going to attempt to do so, it seems like we might as well try and use data that could be relevant, rather than this 1-year and 3-year return garbage.

Regardless, I still think that which fund you invest in isn’t nearly as important as your ability to stick with your plan.

As far as casino gambling goes, blackjack is one of the better games to play. Your chances of winning any given hand are fairly decent: Less than–though not much less than–50%.

However, because your chance of winning a hand is less than 50%, the more hands you play, the less chance you have of coming out ahead in the end.

Mutual funds work the same way.

Study after study has shown that the higher the operating costs of a fund, the worse its chances of beating the relevant index in any given year. This shouldn’t really come as any surprise. For every additional percentage of operating costs, the fund managers must outperform the market by 1% in order to justify the use of their fund over an index fund.

Of course, not every manager can succeed because, for every dollar that outperforms the market, there’s a dollar underperforming by an equal amount. So (prior to considering costs) half of all dollars in non-index funds outperform the market, and the other half underperform. Therefore, when looking at after-cost returns, we must conclude that greater than half of all non-index-fund-dollars will underperform the market each year.

So if your probability of outperforming an index fund is less than 50% each year, what are your chances of outperforming over a multiple-decade period? It’s rather like playing 30 hands of blackjack and expecting to come out ahead, isn’t it?

Takeaway: If you’re going to invest in actively-managed funds, make darned sure they’re low-cost ones.