The link with this post will take you to a YouTube video that dramatizes the perils of investing in a handful of actively managed mutual funds.

For those who prefer words to film, here’s the same story in prose.

When you invest in stocks or bonds, you can do so either through passive index funds that simply own (or replicate) all or part of the total stock or bond market, or through “active” managers that attempt to outperform the market return and charge relatively high fees. If you hire the latter, you are incurring “active risk”: the risk that your active managers’ returns turn out to be less than those of the market, despite high fees.

Investors should never take risks that they are unlikely to get paid for and that they can avoid. Active risk meets both these criteria; that is, you’re not likely to get paid for taking this risk, since masses of independent research shows that two-thirds of active fund managers consistently underperform the market, and that there’s no way to identify in advance which managers will be in the one-third that successfully beat the market in the future.

Of course, fund management companies tout the success of those funds in their line-up that have outperformed over the past one-, or three-, or five-year periods. Unfortunately, the implication that this success will persist is completely misleading: how a fund performed in the past does not tell you how it will perform in the future.

Your risk of underperforming the market actually compounds when you invest with multiple active managers–for example, if you invest in several actively managed stock mutual funds.

How come? Three reasons:

    • First, 2/3 of active managers will underperform in any given period.
    • Second, we can’t tell in advance which managers will be among the 1/3 who outperform.
    • Third, the managers who underperform do so by a larger margin, 1.6 percentage points on average, than the margin of outperformance of the winners, which averages 0.6 percentage points.

    So let’s imagine that you have a large leather bag full of marbles, and 2/3 of them are red and 1/3 green. You have to draw marbles from the bag without looking inside.

      • Every time you pick a green marble, you get somewhere from 10 cents to $1.50, with an average payout of 60 cents.
      • Every time you pick a red marble, you have to pony up anywhere from 10 cents to $2.50, with an average payment of $1.60.

      You see where this is going, right? Not only is the deck stacked against you because most of the marbles are red, but over time you’re also going to lose more on the average red marble than you win on each green. What will happen eventually? Well, obviously you’ll eventually go broke—unless you quit playing.

      The reason most investors continue to play this game is because they are repeatedly sold and severely infected by two  delusions:

      1. If a fund performed well in recent years it will perform well in future years.  Extensive objective research has proved that this statement is demonstrably false.
      2. We—or our financial advisor—can predict which actively managed funds will perform better and which will perform worse in future years. Extensive objective research has proved that this statement is also demonstrably false.

      So as a retail investor, you should follow the advice given again and again and again by all the disinterested experts who have written on this subject: quit playing the high cost, active risk game where the deck is doubly stacked against you, and buy index funds instead, where you know you will earn the return of the stock or bond market and not incur the risk of underperformance. Investing is difficult and risky enough without increasing your chances of failing to meet your goals by taking on a risk you’re not going to get paid for.