The Big Lie Is a Cruel Hoax

A broker speaks on the telephone while working in the trade room of a Portuguese bank Wednesday, July 18, 2012, in Porto, Por
A broker speaks on the telephone while working in the trade room of a Portuguese bank Wednesday, July 18, 2012, in Porto, Portugal. Bailed-out Portugal has managed to sell euro 2 billion ($2.5 billion) in short-term bonds at a lower cost than Spain, suggesting the much larger country's troubles are not spilling over to its neighbor. Spain and Italy are struggling to borrow money at affordable rates, and Greece, Ireland and Portugal have needed bailout loans from the other countries. (AP/Paulo Duarte)

Nothing gets my attention quicker than the perpetuation of what I call "the big lie". It is usually presented like this: Index based investing is fine if you are not too bright, or lazy and don't have the time to do the research, or if you are willing to settle for "average" returns. Otherwise, you should include actively managed mutual funds (where the fund manager attempts to beat the returns of a designated benchmark, like the S&P 500 index) in your portfolio."

Ironically, the opposite is true. Really smart people have done the research and reached this conclusion: There is no reliable way to predict which actively managed funds are likely to outperform their designated benchmarks in the future. You can find quotes from a sampling of these people here.

Fortune Magazine compiled a list of the smartest people alive in finance in 1998. It included Eugene Fama, Nobel Laureate Merton Miller, Nobel Laureate Myron Scholes, Kenneth French, Roger Ibbotson and Rex Sinquefield. Extensive research by these distinguished scholars supports the view that there is no way to predict outperformance by actively managed funds.

You can find reams of additional research debunking this myth in my books and in books written by Burton Malkiel, William Bernstein, Michael Edesess (who wrote The Big Investment Lie), Mark Hebner, Rick Ferri, Allan Roth, John Bogle and many others.

The perpetuation of the myth that you can pick outperforming actively managed funds through "research" is a cruel hoax. It makes ordinary investors feel inadequate when their efforts fail. Most don't realize that extraordinary resources by researchers with advanced degrees in finance have been devoted to finding the magic bullet that would "beat the markets." None have succeeded.

The fruitless search for predictive factors of outperforming funds is harmful to your financial health. In a recent blog on Forbes, Richard Ferri calculated the probability of selecting a winning actively managed fund for different categories of stocks and bonds ranged from a low of 22 percent to a high of 32 percent.

Most investors hold a portfolio of mutual funds, and not just a single fund. Ferri reached some startling conclusions about the probability of a portfolio of all actively managed funds beating a comparable portfolio of all index funds. This statistic stood out: An actively managed portfolio consisting of five funds held for 20 years had only a 2 percent chance of beating a comparable portfolio of index funds. Ferri concludes that "[T]he evidence in favor of all index funds, all of the time, is irrefutable, overwhelming and important to all investors."

Don't be misled by statements indicating there is some way you can identify actively managed funds that will outperform their benchmarks prospectively. As one commentator noted, relying on past performance and hoping it will persist is "like driving forward while looking through the rear view mirror."

Smart, diligent, responsible investors are familiar with the peer-reviewed data supporting Ferri's conclusion. If your portfolio does not consist of "all index funds all the time", it's because you are being fooled into believing it's your fault that your actively managed portfolio is underperforming its benchmark.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book is The Smartest Money Book You'll Ever Read. The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.