Over 20 years ago, in the book “Get Rick Slowly” William Spitz wrote that, “The most difficult part of investing is understanding and evaluating risk. ” This line struck me when I was reading this wonderful book recently. The reason that understanding and evaluating risk is so challenging is that there are many types of investment risk and without risk, there are no investment returns so it’s a part of life.
For example, there is:
- Credit risk (the potential for a bond to default)
- Volatility risk (the short-term ups and downs of the value of stocks, bonds and mutual funds)
- Goal-risk (the potential that you won’t have enough money to send your daughter to college or the possibility that you won’t have enough money to retire on when you want and live in the lifestyle you want)
- Inflation risk (the loss of purchasing power).
And several others. We’re going to dive into the topic of investment risk and how to address it in the next few blog posts. For now, keep this in mind: risk and return are related. While everyone wants a high return and low-risk investment, there is no such thing.
Here is what we know about active investment management:
1. Active Management is expensive. The average expense ratio of actively managed funds is 1.29% vs. an average of .80% for all passive funds and .38% for all DFA Funds. ETFs are even cheaper.
2. Active Management doesn’t consistently work well. Over the last 5 years (2009 – 2013), only 39% of U.S. Equity funds and 29% of International funds outperformed their benchmarks.
3. In those rare instances when Active Management works, it rarely lasts. Over the last five years (through March), only 2 out of 2,862 active U.S. Equity funds stayed in the top quartile of performance in each of the last 5 years. That’s right 2 funds! The other 99.93 % might have enjoyed a good year or two of performance but were unable to produce consistently good performance. And by the way, 852 of those funds (or 30%) merged with other funds or went out of business.
4. You’d get better results flipping a coin. While we don’t recommend coin flipping, roulette or other games of luck as an investment strategy, pure chance would suggest that at least 3 funds (instead of 2) should have achieved consistent outperformance over the last 5 years.
Think about these facts the next time you wonder if your investment approach is efficient and effective.