Stock return chart of the day

By Felix Salmon
April 11, 2009

stocks.jpg

Nick Gogerty has a great post using this chart to explain why mutual fund managers are doomed to underperform the stock market. Yes, stocks as a whole do rather well — but only if you include the really spectacular winners. If you buy the market and a whole and make money doing so, you’re basically following a strategy of making sure that you include the spectacular winners by making sure that you’re including pretty much everything.

Nick explains that while the mean return for the stock market is quite good (or at least was between 1983 and 2007, which was the dataset for this graph), that isn’t true for other kinds of average:

The median and mode for shares returns is actually well below the cap weighted index which is closer to the mean. The charts above indicate 64% of shares under perform the index. This means that managers who “tilt” or weight their portfolio to their best ideas are statistically taking a random sample and doing bad things, increasing the odds of picking sub-index performance and in so doing also diminishing the allocations to the potentially significantly positive outliers that help deliver the mean performance.

Any good fund manager will tell you that, in hindsight, his best stock picks weren’t his best ideas. But it’s really hard to find a fund manager who won’t overweight his portfolio to the stocks he most believes in. And that’s one of the reasons that I’m suspicious of value investing: it’s full of investors who have done so much homework that they’ve convinced themselves they’re right — and they just won’t let go. This results in great stories, but it doesn’t necessarily result in great returns. Quite the opposite.

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