Kim Snider
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May 15, 2009

Mutual Fund Returns - Skill or Luck?

Now that we must rely on our investment prowess to provide sustainable retirement income, it is more important than ever to understand investing in mutual funds does not create wealth - quite the opposite.

Two of the most pre-eminent economists alive today, Eugene Fama and Kenneth French, have recently published a paper that revisits, yet again, the question of whether anyone can accurately pick stocks. Their paper is titled, "Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates."

Here is the long and short of it, from the abstract:

"Bootstrap simulations produce no evidence that any managers have enough skill to cover the costs they impose on investors. If we add back costs, there is some evidence of inferior and superior performance (non-zero true alpha) in the extreme tails of the cross section of mutual fund alpha estimates. The evidence for performance is, however, weak, especially for successful funds, and we cannot reject the hypothesis that no fund managers have skill that enhances expected returns." (emphasis mine)

So why do Americans continue to buy actively managed mutual funds when it almost guarantees sub-par performance? Largely because they don't know any better.

One of the most dangerous principles is social proof, which says in the absence of certainty, humans look around to see what others are doing and do the same thing. The more uncertainty, the more likely we are to stick close to the herd. This  behavior was very helpful, for the species, in getting to the top of the food chain. However, not so helpful in getting to the top of the investor food chain.

If you understand that markets don't reward all participants equally, you will also understand that doing what everyone else is not going to get you to the top of the investment heap.

If you are interested in what you might do as an alternative, I would encourage you to sit down with any number of our free special reports available to Snider Insiders (free registration required) and read them carefully. Specifically, I would recommend "How to Not Just Survive, But Thrive, in Turbulent Financial Markets."

Tip of the hat to Jim Mahar, of for the heads up on this paper.

No statement in this post should be construed as a recommendation to buy or sell a security or to provide investment advice unless specifically stated as such. All investments involve risk including possible loss of principal. Complete information can be found on our website or by calling 1-888-6SNIDER.

Focus of This Blog

Kim Snider is an author, speaker and host of Financial Success Coaching, Saturdays at noon, on KRLD Newsradio 1080, Dallas - Fort Worth. This blog is primarily devoted to empowering individual investors with information to help them be good stewards of their money. Above all, it is about achieving true financial success. Kim's book, How To Be the Family CFO: Four Simple Steps to Put Your Financial House in Order is in bookstores now. Order yours from Amazon or other fine booksellers today.

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