I’m currently reading Larry Swedroe’s Wise Investing Made Simple, and I came across an example of something I’ve been wanting to highlight for a while. Here’s the quote:
“For the twenty-year period from 1979 to 1998, just 14 percent of the funds outperformed their benchmark on an after-tax basis.”
What’s the problem here?
The problem is this only shows one thing–it shows that such an event can occur, not that it is likely to occur. In other words, it shows possibility, not probability.
I’m obviously a big fan of index funds over active funds, but there’s nothing in this particular factoid that should necessarily lead us to think that the following 20-year period should exhibit a similar result.
Quick Disclaimer
I have nothing but respect for Mr. Swedroe. This is the first book of his that I’ve read, and overall I’d highly recommend it. Also, Larry is supremely helpful for many investors over on the Boglehead forums. The only reason I’m picking on him is that his is the book I happen to be reading at the moment.
Also, Larry is not the only person who does this. I’m writing about it precisely because it is so common, even among excellent authors–John Bogle does it, William Bernstein does it, etc. And if you look back through the archives on this blog, I’m sure I’m guilty as well.
We wouldn’t let others get away with it.
Imagine if somebody made the following claim (which I’m admittedly making up on the spot):
“From 1998-2002, you could have outperformed the market by investing in the S&P 500, but getting out of the market on days when Dr. Phil was scheduled to appear on Oprah.”
What would we say to this investor? We’d say that his strategy is nonsense.
And how would we go about proving that? We’d look at how the strategy performed over other periods. If the strategy was unsuccessful over the majority of other periods tested, we’d conclude that the strategy’s success during that one particular period was purely due to randomness.
So why, then, do we let authors get away with quoting what happened over one particular period?
Show us repeated results, please.
For example, in the 20-year study that Swedroe quotes, they could have shown us what the results looked like in each of the 11 10-year periods included in those 20 years. That information would tell us (a little bit) more about the probability of such a phenomenon occurring again.
Conclusions:
For the writers (or financial advisers) among us: I think we owe it to our readers (or clients) to provide more thorough evidence of our claims. Yes, it will be a pain in the neck sometimes. I’d argue that it’s worth it.
For all investors: Please be aware that just because something has happened over one particular period, it isn’t necessarily likely to happen again. Remain skeptical and ask for more data/information if somebody tries to prove something to you using such anecdotal evidence.
Want to learn more about investing?
Enter your email address to receive free updates from this blog. (You won't receive any emails other than blog posts, and you can unsubscribe at any time.)Like Cliffs Notes...for Investing
| If you're looking for a brief, plain-English introduction to investing, I'd encourage you to pick up a copy of my book: Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less. |  |
{ 5 comments… read them below or add one }
Is that why you go for long periods of time, showing multiple 20 year periods (i.e. from before 1929 all the way up through 2000)?
Yeah, that’s precisely what I’m trying to do.
To me, looking at several 20-year periods tells us a great deal more than looking at one 20-year period.
And I’d argue that it also provides more helpful information than simply saying “here’s what happened over the 80-year period from 1929-2008.” I don’t know many investors who are looking at 80-year time-frames.
The evidence you seek is available. Mutual funds are a bad deal for individual investors.
The bottom line is that professional money managers – as measured by the performance of actively traded mutual funds – cannot outperform the major benchmark indexes. And even if they could, that 1 to 2% management fee would turn the fund into an under-performer.
I don’t have all the evidence at my fingertips, but for starters, try: The Great Mutual Fund trap by Baer and Gensler
Hi Mark.
There’s no particular evidence I’m looking for. I don’t have any issues with the conclusion (that active funds consistently underperform low-cost index funds), because I’ve seen plenty of other evidence and studies that show the same thing.
My issue is with the technique of showing one incidence of something happening and asking readers to come to the conclusion that it is likely to continue to happen.
That said, thank you for the book recommendation. I just took a look at it on Amazon, and it looks quite interesting.
Agree. One example of something proves nothing.
The number of data points is very important when trying to convince others (or yourself) that something is true.