Where (Not) To Invest
Introduction
At least once a week, I hook up with friends @ the bar & have a discussion for a few hours, over whiskey & cigars.
This week the topic was: "Where (not) to invest your money - Beware of Mutual Funds" This post distills the main points of our discussion.
Motivation
Building a nest-egg that can keep us comfortable when we retire is a tough job. This is because:
It's indeed true that as you grow older, you should decrease your exposure to the stock market & start putting your money into [low risk, low return instruments. But the problem is that folks make the mistake of exiting too early from the stock market. This can have the disastrous consequence of your retirement money running out before you're dead! This is because we:
One solution is to invest in mutual funds. This is because your money is now being professionally managed by the fund manager who has his ear to the stock market. Problem solved, right? Wrong!
The aim of the rest of this post is to tell you why investing in mutual funds is a bad idea (or at least one that should be undertaken with a great deal of wariness).
Cooking the books
It's easy to become seduced by the spectacular numbers put out by companies selling mutual funds. However, these figures are usually not accurate. They suffer from what is called "Survivorship Bias."
See, it is extremely hard, almost impossible to beat the market. Conventionally, this idea is called as the "Efficient-market hypothesis". However, due to the sheer number of players, statistically a few of them might end up with above average returns. This same state of affairs holds for the mutual funds as well.
The track record of a vast majority of mutual fund managers, is underwhelming. But because each fund manager will manage several funds & there are many fund managers in the mutual fund market, it's a statistical fact that a tiny proportion of them will end up beating the market.
What the mutual fund companies do is that they quietly close all those funds that haven't been doing well & incorporate their assets into those few funds that glittered. This is what is advertised to the general public - ONLY those funds that have survived.
Professional Incompetence
The murkiness gets even worse with hedge funds. These buggers charge not only a 2% management fee, but also take 20% of any profits. Their justification for doing this - their spectacular record of beating the market. But this is just an eyewash.
See, not only do hedge fund numbers suffer from Survivorship Bias (the only hedge funds reporting their results are those that have survived), but they also suffer from another kind of bias: "Back-fill Bias."
Not only do they choose a manager who has posted above-average results to head a hedge fund, they also include his past history, which tends to inflate the numbers. This is because only the "good" managers' numbers are included while the history of the vast majority of other managers disappears.
So, you’ve got survivorship bias taking out bad records and then you’ve got backfill bias adding good records. They both cause the universe of active management returns to appear to be better than the reality. How much better? Well, it's estimated that Survivorship Bias adds about 4% annually & Back-fill bias about 7%, which gives about 11% annual inflation in their figures.
When you factor this + the ridiculously high fees, then hedge funds don't seem a very promising investment.
Conclusion
Be real careful about putting your hard-earned money into vehicles like Mutual Funds, Hedge funds & such. This is because these guys report only those numbers that show them in good light.
As a coda, let me end with this sobering passage from John Ioannidis' paper published in the PLoS journal of Medicine, provocatively titled, "Why Most Published Research Findings Are False." Apparently, the very same tactic is used by some asshole scientists in the biological sciences as well. I suppose this pathetic state of affairs explains why we get contradictory results each year about coffee/alcohol being good/bad for us, eh? :)
"The high rate of non-replication of research discoveries is a consequence of the convenient, yet ill-founded strategy of claiming conclusive research findings solely on the basis of a single study assessed by formal statistical significance, typically for a p-value less than 0.05."
At least once a week, I hook up with friends @ the bar & have a discussion for a few hours, over whiskey & cigars.
This week the topic was: "Where (not) to invest your money - Beware of Mutual Funds" This post distills the main points of our discussion.
Motivation
Building a nest-egg that can keep us comfortable when we retire is a tough job. This is because:
- Saving money requires discipline; &
- Our efforts are constantly being undermined by inflation.
It's indeed true that as you grow older, you should decrease your exposure to the stock market & start putting your money into [low risk, low return instruments. But the problem is that folks make the mistake of exiting too early from the stock market. This can have the disastrous consequence of your retirement money running out before you're dead! This is because we:
- have longer life spans relative to previous generations; &
- live in more expensive times.
One solution is to invest in mutual funds. This is because your money is now being professionally managed by the fund manager who has his ear to the stock market. Problem solved, right? Wrong!
The aim of the rest of this post is to tell you why investing in mutual funds is a bad idea (or at least one that should be undertaken with a great deal of wariness).
Cooking the books
It's easy to become seduced by the spectacular numbers put out by companies selling mutual funds. However, these figures are usually not accurate. They suffer from what is called "Survivorship Bias."
See, it is extremely hard, almost impossible to beat the market. Conventionally, this idea is called as the "Efficient-market hypothesis". However, due to the sheer number of players, statistically a few of them might end up with above average returns. This same state of affairs holds for the mutual funds as well.
The track record of a vast majority of mutual fund managers, is underwhelming. But because each fund manager will manage several funds & there are many fund managers in the mutual fund market, it's a statistical fact that a tiny proportion of them will end up beating the market.
What the mutual fund companies do is that they quietly close all those funds that haven't been doing well & incorporate their assets into those few funds that glittered. This is what is advertised to the general public - ONLY those funds that have survived.
Professional Incompetence
The murkiness gets even worse with hedge funds. These buggers charge not only a 2% management fee, but also take 20% of any profits. Their justification for doing this - their spectacular record of beating the market. But this is just an eyewash.
See, not only do hedge fund numbers suffer from Survivorship Bias (the only hedge funds reporting their results are those that have survived), but they also suffer from another kind of bias: "Back-fill Bias."
Not only do they choose a manager who has posted above-average results to head a hedge fund, they also include his past history, which tends to inflate the numbers. This is because only the "good" managers' numbers are included while the history of the vast majority of other managers disappears.
So, you’ve got survivorship bias taking out bad records and then you’ve got backfill bias adding good records. They both cause the universe of active management returns to appear to be better than the reality. How much better? Well, it's estimated that Survivorship Bias adds about 4% annually & Back-fill bias about 7%, which gives about 11% annual inflation in their figures.
When you factor this + the ridiculously high fees, then hedge funds don't seem a very promising investment.
Conclusion
Be real careful about putting your hard-earned money into vehicles like Mutual Funds, Hedge funds & such. This is because these guys report only those numbers that show them in good light.
As a coda, let me end with this sobering passage from John Ioannidis' paper published in the PLoS journal of Medicine, provocatively titled, "Why Most Published Research Findings Are False." Apparently, the very same tactic is used by some asshole scientists in the biological sciences as well. I suppose this pathetic state of affairs explains why we get contradictory results each year about coffee/alcohol being good/bad for us, eh? :)
"The high rate of non-replication of research discoveries is a consequence of the convenient, yet ill-founded strategy of claiming conclusive research findings solely on the basis of a single study assessed by formal statistical significance, typically for a p-value less than 0.05."