The Fallacy of Persistency
(Of Superior Investment Performance)

The delightful William Bernstein, in his great work, The Intelligent Asset Allocator, presents the argument against the existence of the persistency of superior performance in mutual fund management (the fallacy of persistency) by first talking baseball:

“Consider baseball hitters. You say there is such a thing as “hitting skill”? A trivial thing to ask, of course, but still easy to test.

The batting analogy is useful because it forces us to think about the statistical nature of skill. Probably the best way to define it is in terms of persistence of performance. Let’s say that the mean batting average among baseball players is .260. Now let’s look at last year’s .300 hitters. Were there no such thing as batting skill, then their performance this year would be merely average --- in other words, .260. Of course, one year’s .300 hitters as a group always do well above average the following year by such a wide margin as to remove all doubt that their performance is due to skill, and not chance. Interestingly, when exposed to the harsh light of statistical analysis, more than a few sports beliefs do fail to pass muster. One of these is the “hot hand” phenomenon in basketball. Feeding the ball to the shooter on a “hot streak” is a time-honored court stately. And yet, a player who has recently hit a higher percentage of goals than his usual is no more likely than usual to do so going forward. That is, such performance does not persist. This highlights a human foible that has great import in finance --- our tendency to see patterns where there are in fact none.

And yet, it was not until 30 years ago that researchers began to apply the same techniques to money managers. It turns out that for all practical purposes there is no such thing as stock-picking skill. The first to document this was Michael Jensen, who, in a landmark paper published in 1968 in the Journal of Finance, looked at mutual fund performance for the 20 years from 1945 to 1964 and found no evidence of persistence of fund performance. Last year’s hot manager, on the average, will be simply mediocre next year. Since then, dozens of careful analyses of money manager performance have been done, and the net results are eye opening. Many studies show a small amount of persistence, but the effect is always so tiny that after you pay fund expenses, you still come out behind the market performance, on average. Let’s take a look at some of the data. A study done by Dimensional Fund Advisors, an institutional investment firm in Santa Monica, CA, looked at fund performance for the period January 1970 to June 1988. They examined the top 30 diversified mutual funds for sequential five-year periods and then subsequent performance. The results are tabulated in Table 6-1. In each example, the top funds for the first period underperformed the S&P 500 in the subsequent period and in two of the five examples actually underperformed their peers as well.

Does this look like the performance of highly skilled money managers? No. We are looking at the proverbial bunch of chimpanzees throwing darts at the stock page. Their “success” or “failure” is a purely random affair. The most successful managers wind up being interviewed in Money, The New York Times, and Uncle Lou. Their assets under management balloon, and the shareholders’ admiration is vindicated by the media attention.

However, time passes, and the laws of chance eventually catch up with these folks. Hundreds of thousands of investors find that the handsome prince managing their funds turned out to be just another hairy simian.”

--William Bernstein, The Intelligent Asset Allocator, Chapter 6, Market Efficiency, pages 85-88)

More Support for the Fallacy of Persistency

Professor Burton Malkiel points to this same fallacy of persistency. In his seminal work, A Random Walk Down Wall Street (2003 Edition), Professor Malkiel has a chapter entitled “How Good Is Fundamental Analysis” replete with numerous specific examples of false financial gurus who happened on the financial stage for brief moments of so-called financial brilliance. It is very sobering reading. While their flames burn bright, these “experts” attract many followers and oodles of money to their “system”. Only then does the fallacy of persistency once again rear its ugly head and the great geniuses become once again your ordinary “high priced” mediocrities or worse.

Professor Malkiel provides the results of two of his “persistency” studies. The first compares the top 20 equity mutual funds of the 1970s against the performance of these “stars” in the decade of the 1980s. The second compares the top 20 equity mutual fund of the 1980s against the performance of these “stars” in the decade of the 1990s. What facts emerge? Well in the first study, the top 20 funds of the 1970s (whose performance, collectively, had exceeded the average of all equity funds in that 1970s period by a margin of 19% per year to 10.4% per year), in the following 1980s period performed slightly worse than average (a margin of 11.1% per year to 11.7% per year for the average fund).

In the second study, the top 20 funds of the 1980s (whose performance, collectively, had exceeded the average of all equity funds in that 1980s period by a margin of 18% per year to 14.1% per year), in the following 1990s period performed worse than average (a margin of 13.7% per year to 14.9% per year for the average fund).

Should this data from Professor Malkiel, the Jensen data and the Dimensional Fund Advisors data (see above) give any intelligent investor pause in “going with the winners” from the last decade in hopes that these winners will produce superior returns in the next decade? Absolutely! There is little reason to believe a financial guru is going to enhance your prospects for future returns based on a wonderful track record of the past, no matter how boldly they plaster their “superiority” in financial advertisements or talk shows. It is a false hope and an expensive hope. False because, as just demonstrated, the facts simply do not support a conclusion that past performance of mutual fund managers, in itself, provides any useful information about future performance. Expensive because the incessant, insipid, promotion of past performance “track records” clearly, intentionally, and willfully leads investors away from the two determinants of future performance that do matter: controlling investment Costs and engaging in proper asset allocation. These are the investment factors that actually lead to long-term superior investment performance. And what investment instruments shine most brightly in regards to these two vital investment factors? INDEX FUNDS!

Summary

Understanding the Fallacy of Persistency (of superior mutual fund performance) is essential to intelligent investment decision-making, and yet, a belief in persistency is one of the most tenacious of investment illusions. (See Investment Illusion elsewhere on this web site. Also see Fooled by Randomness). The financial Pied Pipers (and their advertising firms) who exhort us to “follow them” are VERY VERY SEDUCTIVE. But, to enhance your chances of investment success, you must follow the Evidence, not the hoopla. And that evidence is clear: 1) low-cost index funds have outperformed the average managed mutual fund historically and 2) there is no reason to believe that those few managed funds who have performed well historically will not be the average performing (or worse) mutual fund of the future.