You just can’t trust stock picking.
I don’t mean stock pickers lie about everything. What I mean is you can never trust it to keep working, even when it has worked in the past.
Have you ever made a good stock pick?
I have a relative who bought a few stocks that did quite well for a few years. She figured she knew something about investing. The reality was she just got lucky, but it is difficult for an unseasoned investor to see it this way.
She went ahead and bought some more stocks. They did horrible and she lost a lot of money. This all occurred over the course of a couple of years.
Now imagine she was a seasoned investment professional that had outperformed the market for over 20 years? At that point would you trust her “skill” to keep working? Most people would…..and they are wrong to do so.
Bill Miller and the Legg Mason Capital Management Value Trust
Bill Miller was a highly regarded investment manager whose mutual fund (Legg Mason Capital Management Value LMVTX) outperformed the S&P 500 index for over 20 years. Interestingly, this fund provides one of the greatest examples ever of why NOT to use mutual funds with active managers. After over 20 years of great performance, the fund cratered.
Fake Math vs. Real Math
A lot of investment advisors use bad mathematical logic when suggesting mutual funds to their clients. Here is how their math works. “This fund has outperformed its benchmarks for several years. I have all sorts of fancy statistics on its out-performance. I will recommend it because I think this will continue.”
Let’s step back and take a look at whether there is any connection whatsoever between past performance of a stock picker and their future performance. If there is no connection, then it doesn’t matter how much they outperformed the market in the past.
Studies on this subject have been done over and over and over (the first was done in 1932). The results always come out the same. There is virtually no connection between past performance of stock pickers and future performance. So it doesn’t matter how great a mutual fund manager may have looked in the past. You just can’t expect that has any bearing on what they will do in the future.
What about that one great manager?
There will always be a handful of managers (like Bill Miller) that can seem to do great year after year. But again, the “real math” shows that with thousands of mutual funds out there, you would expect a small handful to get lucky and do great year after year just on chance alone.
And what eventually happened with Bill Miller?
The math caught up with him, as it always does. Math is a relentless adversary.
After years and years of out-performance the fund finally cratered. The result — after 31 years of history the fund has almost the exact same performance as the S&P 500, although it did it with more volatility. Even with this star mutual fund, you would have done just as well over 31 years if you had an S&P 500 index fund.
Below: Legg Mason Capital Management Value vs. S&P 500. April 16, 1982 – Sept 30, 2013