All you have to do is choose the right money manager. It’s simple. If you can just figure out which manager will outperform the market every year you can be rich. You can retire early and live the life you’ve always wanted to. It’s just that simple!
Until it isn’t.
If we had 1,000 money managers line up and you were told to pick which one would outperform the market over the next ten years, odds are you would be wrong every time. It’s simple probability. There is a 1/1000 chance of you being right. (So you’re telling me there’s a chance!)
Since we don’t know at the start which money managers are ‘good’, we are forced to look at the only ‘reliable,’ tangible evidence we have…
So we look at past performance trends and find those managers who have had the best performance over the past 5-10 years. And we have arrived. We have found the key to outperforming the market. And we can’t get in fast enough.
The problem with this tactic, though, is that markets are efficient (or at least highly efficient). This efficient market hypothesis states that it is impossible that anyone can beat the market over an extended period of time. This means that the manager’s outperformance you loved so much was likely due to random probability and not skill.
Just based on sheer numbers, someone or even maybe a few people are bound to beat the market over a 5-10 year period.
The odds of that same manager continuing their ‘lucky’ streak into the future, however, is also completely random. You could simply invest your money with your grandma and have just as good a chance of outperforming the market as this money manager does.
Said a different way, the money manager who outperformed has no secret sauce. He is simply the result of basic probability. With so many money managers, someone is bound to have a streak that looks like skill.
Just so, the money manager who underperformed is probably not an idiot. Their underperformance is also the result of basic probability.
Looking forward, each of these managers has exactly the same chance of out performing the market in the future.
This means that it doesn’t matter which you choose. You could choose the person who outperformed every year or the person who under-performed every year. And you would still have the same chance of future success.
Past Results and Future Returns
Depending on the past to predict your investing future is a terrible idea. Why do you think every mutual fund company has to have the “Past results are no indication of future returns” disclosure. The SEC forced them to start putting that out there to help investors understand that past performance has ABSOLUTELY NOTHING to do with future returns.
Markets are random. And those managers who outperformed did so by random probability and good luck.
What to Do
So… If you can’t predict the future and you can’t rely on the past to predict the future, what are you to do?
Own every company and don’t worry about. Through an index fund. Then, whenever your buddy talks about a bankruptcy looming or a sure fire stock pick or how a presidential election might cause the price of X to skyrocket, you can say with confidence these absolutely freeing words. Words that will never let you down and could save you from a world of heartache and regret later in life.
“I don’t know, and I don’t care!”