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Manager Risk? No thanks.

The state of Oregon is suing Oppenheimer Funds for understating the risk it took while managing a bond fund in the state’s college savings plan. From the Wall Street Journal:

Oregon charges that Oppenheimer Core Bond fund, which was in the state’s 529-plan options billed as “conservative,” became significantly more risky starting in late 2007 or early 2008. The fund lost 36% of its value in 2008, but its benchmark index, the Barclays Capital Aggregate Bond Index, rose 5.2%.

“The Core Bond Fund was no longer a plain bond fund,” the complaint says. “It had become a hedge-fund like investment fund that took extreme risks.”

When you invest in an actively-managed fund, there is a chance that the manager will make some excellent decisions (or get lucky), and thereby substantially outperform the relevant index/benchmark.

On the other hand, there is also a chance that he’ll get horribly unlucky or make a series of bonehead mistakes, thereby causing the fund to severely underperform.

In other words, active management makes your returns less predictable. It adds an additional level of risk.

The way I see it, taking on additional risk only makes sense if you’re being compensated with an increase in expected return. Unfortunately, as we know, choosing active funds over passive funds does not increase your expected return.

[Quick note: I say “expected return” rather than simply “return” because the very nature of taking on risk means that returns are not possible to predict precisely. Example: Stocks have a greater expected return than bonds, but there’s no telling ahead of time whether stock returns will be greater or less than bond returns in any particular period.]

Many investors gain comfort from knowing that a professional is managing their money. Odd as it may sound, I gain comfort from knowing that nobody is managing mine.* 🙂

*Yeah, OK. I guess I’m managing it in the sense of choosing an asset allocation, selecting specific index funds, and so on. But you get the idea.

Skill vs. Luck in Mutual Fund Performance

Let’s imagine a hypothetical group of 1,024 actively-managed funds. If we look at pre-expense results, roughly 50% of the funds should outperform the market each year. That means that after 7 years,

  • 8 of the funds will have outperformed the market every year,
  • 64 funds will have outperformed the market in at least 6/7 years, and
  • 232 funds will have outperformed the market in at least 5/7 years.

And that’s based purely on luck. No need for any fund management skill at all.

According to the Investment Company Institute, at the beginning of 2002, there were 4,756 equity mutual funds. Using our numbers from above, we can see that pure luck would account for 1,077 different funds outperforming the market in at least 5 of the last 7 years on a pre-expense basis. There would even be 37 funds that would have outperformed in each of the last 7 years.

And yet, I suspect that most of us are inclined to think “wow, this guy is good!” when we see a fund with a record of beating the market for each of the last 7 years. Oops.

The simple fact that a fund manager has outperformed the relevant benchmark index doesn’t tell us very much at all.

What about extended periods of outperformance?

According to Jeremy Siegel (in Stocks for the Long Run), in order to be able to say with 95% confidence that a fund manager’s performance is due to skill rather than luck, he’d need to outperform the market by an average of 4% per year for roughly 15 years. (If the fund was only outperforming by 3% annually, it would take more than 20 years.)

The problem, however, is that by the time we’ve seen a fund manager outperform the market for 15 years in a row, it’s not particularly likely that he (or she) will be managing the fund for much longer.

So how should we choose funds then?

Of course, picking an actively-managed fund with a long-term record of outperformance is probably better than picking an actively-managed fund with a long-term record of underperformance. But don’t fall into the trap of assuming that a fund manager must be a genious simply because he’s beaten the market for the last several years.

Rather than focusing exclusively on past performance when choosing mutual funds, try doing the following:

How much does your mutual fund cost?

toothpasteI recently watched a Ted talk by Dan Gilbert that I can best describe as an entertaining combination of Nudge, Predictably Irrational, and Against the Gods.

One of the things Dan talks about is that, as humans, we’re not very good at judging value. We have a tendency to judge the value of something simply by comparing it to something else in the near vicinity.

One of the examples Dan used to illustrate his point was the following:

People don’t know whether their mutual fund manager is taking 0.1% or 0.15% of their investment, but they clip coupons to save $1 off their toothpaste.

So true! The average shopper has some idea of what a tube of toothpaste costs. If the price were to drop by $2, we’d notice and perhaps buy a couple extra. If the price were to go up by $2, we might buy another brand instead.

In contrast, the average investor has (I suspect) absolutely no idea what he’s paying for his mutual funds. I imagine this is caused by two factors:

  1. Fund expense ratios are hidden away in rarely-read prospectuses, and
  2. Mutual fund expense ratios just aren’t something that most people spend time thinking or talking about. (But would it really be so strange to bring it up? I mean, people mention it to their friends when they “save” $15 on a pair of jeans, right?)

Price Inelasticity

Economists refer to a good/service as having inelastic demand if consumers continue to buy it at roughly the same rate even when the price increases. The most common example of an inelastic good is insulin. Even if the price of insulin goes up, the people who need it will keep buying it.

It appears that mutual funds prices are fairly inelastic. Sadly, this isn’t because mutual fund managers provide some all-important service.  Mutual fund demand is inelastic simply because people don’t know what they’re paying.

How many people are paying an extra 1% each year without even realizing it, completely unaware that it will cost them hundreds of thousands of dollars over their investing lifetime?

Fortunately, the rise in index fund popularity over the last couple decades might suggest that mutual fund prices are slowly becoming more elastic as investors catch on to the impact of costs on long-term investment results.


First: regardless of which funds you decide to invest in, make sure you at least know what you’re paying for them.

Second: switching to low-cost index funds will save you enough money to buy a lot of toothpaste over a lifetime of investing.

Conflicting Definitions of Risk

  • Finance world’s definition of risk: The likelihood of less-than-expected returns. (Or, “unpredictability/variance of returns.”)
  • Rest of the world’s definition of risk: The likelihood of negative returns. (Or, “the chance of losing money.”)

In my opinion, this is a problem. The finance community uses the word “risk” to mean one thing, while the rest of the world uses it to mean something different (but sufficiently similar to cause confusion).

Contrived Example #1: A particular investment earns a +50% return in 1/3 years, a +100% return in 1/3 years, and a +150% return in 1/3 years. According to most people’s use of the word “risk,” this investment is risk-free. In fact, it’s the best thing they’ve ever heard of!

But according to the official finance definition, this investment is high-risk: Its returns fluctuate dramatically from year to year, and there is a substantial (33%) chance of earning far less than the “expected return” of +100% each year.

Contrived Example #2: A particular investment loses precisely 10% of its value every single year. According to most people, this investment could hardly be called risk-free. But according to the official finance definition, it is risk-free: Its returns are perfectly predictable.

Real World Example

Of course, the idea of an investment with negative real returns every year isn’t hypothetical. It’s called cash.

In an inflationary environment, cash consistently loses value. Unfortunately, many investors significantly underestimate the long-term effects of inflation, so they see cash as “safe.”

And we in the finance community don’t do a darned thing to help. After all, cash earns a fairly predictable (negative) real return. So we confirm the public’s idea that cash is “no-risk.”

Of course, when the investing public hears the finance experts say that cash is “no-risk,” they assume that the experts are using the word “risk” the same way everybody else does. They think we’re telling them that cash doesn’t lose its value. Talk about a miscommunication!

Let’s at least be consistent.

To make matters worse, many people in the finance community switch back and forth between definitions–usually without giving any explicit indication of which definition they’re using.

This particular mistake is consistent through the world of personal finance blogs, and it even happens in many personal finance books. Charles Schwab seems to do it non-stop when he writes, and David Bach does it as well. It’s an easy mistake to make, but it’s a mistake nonetheless.

My suggestions

For investors: When you hear somebody say that something is either risky or safe, just be aware that they could mean either of two significantly different things. If you really want to understand what the person is saying, take the time to figure out which definition they’re using.

For those of us who are personal finance writers or financial advisers: Let’s keep in mind the fact that when we say something is risky (or safe), most people are going to assume we’re using the everyday definition. If we mean something else, let’s at least tell them!

Asset Allocation and Life Expectancy

An asset allocation rule of thumb that’s been used for decades is to set the bond percentage of your portfolio equal to your age, then adjust upward or downward based upon your tolerance for portfolio volatility. So if you’re 40 years old, roughly 40% of your portfolio should be in bonds, and roughly 60% in stocks.

As generally-applicable guidelines go, it’s a pretty decent one. But I think it leaves out something important:

How long do you expect to live?

Let’s imagine two investors: Lucy and Kelsey. Lucy was born in 1950, and Kelsey was born in 1990. As a result of their differing birth dates, Kelsey’s life expectancy is 7 years longer than Lucy’s.

In order to ensure that she has enough savings to pay for those 7 extra years, Kelsey will have to do (at least) one of the following:

  1. Retire later,
  2. Have a lower standard of living in retirement, or
  3. Have more money saved by the time she retires.

Options #1 and #2 aren’t particularly appealing to most people (though personally I’m rather fond of the “don’t retire” idea). That leaves Kelsey with option #3. Before she can retire, she’ll need more money than Lucy needed–even after adjusting for inflation.

In order to accumulate that extra savings, Kelsey has two options:

  1. Invest more inflation-adjusted dollars each year than Lucy did, or
  2. Shift her asset allocation more heavily toward equities–especially during her working years.

Of course, “invest more money” is easier said than done. As a result, it would seem reasonable to me for Kelsey to have a different asset allocation than Lucy.

Unmentioned assumptions

Every article, book, or blog post discussing asset allocation includes assumptions about life expectancy.

For example, I recently finished reading a 1990 edition of Burton Malkiel’s A Random Walk Down Wall Street. In the book, Malkiel suggests various asset allocations for investors of different ages. However, what was an appropriate asset allocation for a 50-year-old investor in 1990 might not be appropriate for a 50-year-old investor today, given a difference of 6 years in life expectancy.

The same thing happens even with articles that were written very recently. For example, if an expert suggests a given asset allocation for a 65-year-old, it’s significant to note whether the expert is suggesting that allocation for somebody who is 65 today, or somebody who will be 65 a few decades from now.

The problem: Laziness

Unfortunately, I doubt that there’s much value in analyzing articles as to their assumptions about life expectancy. Why? Because (I’d bet) most authors aren’t even thinking about it when they write. (And I must admit, I’m guilty too.) We often assume that what is appropriate today will be appropriate 30 years from now, even though one of the fundamental factors–how many years’-worth of money a retiree will need–is constantly changing.

A few years is a big difference.

It may be tempting to look at a 6 or 7-year difference in life expectancy as no big deal. After all, it’s less than a 10% increase. But what’s important is that it can mean a very large percentage increase in terms of length of retirement.

Just look at it this way: It takes a lot of money to pay for 6 years of living expenses.


I don’t have any quick-fix here–no formula where you can plug in your numbers and get the perfect asset allocation. I just think we need to remember that asset allocation isn’t a two-factor decision (i.e., age and volatility tolerance). It depends upon life expectancy as well.

Oblivious Investing–The Book

Oblivious Investing CoverI’ve got a big announcement for today: The final draft for my upcoming book–the companion book to this blog–was just approved. 😀 (I’ve been working on this thing since late last summer, so it’s good to finally get it out the door!)

A little bit about the book:

What is Oblivious Investing about?

Oblivious Investing is not written to be an “everything-you-need-to-know-about-personal-finance” sort of book.

Rather, the book is a story that seeks to convey one idea–the idea that long-term investing is a fairly straightforward endeavor, and it has absolutely nothing to do with all the craziness that we see in the markets from month to month.

Why is the book written as a story?

Investment books typically deal with data, charts, and so on. Investing in real life, however, deals with emotions–uncertainty, excitement, greed, confusion, fear, etc.

Oblivious Investing is written as a story in the hope of bringing the experience of reading the book closer to the real life experience of creating and implementing an investment plan.

In other words, the goal of the book is not just to explain the principles of prudent investing, but also to prepare the reader for some of the psychological challenges that will arise during a lifetime of investing.

Stay tuned for more info.

Like I said, the final draft was just approved, so it should be up on Amazon in the not-too-distant future. I’ll let you know once I know more. 🙂

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