Perhaps the biggest winner after President Barack Obama on election night was
Nate Silver, the statistician who forecasts elections for The New York Times.
For the second time, he correctly predicted the outcome of the presidential race in at least 49 states. Silver's running forecasts on his FiveThirtyEight blog, which gave Obama anywhere from a 61 to 90 percent chance of winning, were repeatedly accused of being biased, inaccurate and "jokes."
"Is it possible this whole thing is playing out before our eyes and we're not really noticing because we're too busy looking at data on paper instead of what's in front of us?" former Reagan speechwriter Peggy Noonan wrote Monday. She predicted a Romney victory based, in part, on the lawn signs she saw in Florida.
Silver's data-driven process offers lessons to all investors. In fact, Silver devotes an entire chapter to our fallibility as investors in his recent book, "The Signal and the Noise: Why So Many Predictions Fail -- But Some Don't."
Silver asks readers to think about future events as probabilistic forecasts. What are the chances Obama will be elected? What is the likelihood the 2012-13 Portland Trail Blazers will make the playoffs?
This way of thinking acknowledges that our own judgments aren't precise and that the range of outcomes is greater than win or lose, us versus them.
Then Silver goes one step further. He reduces the impact of individual biases (Noonan's lawn signs) by aggregating, or adding, multiple polls together. In addition, he weights those polls based on their recentness and historical accuracy.
He also adjusts them based on other factors that could skew the polling results, such as voter turnout, and nonpoll factors, such as favorability ratings and economic indicators.
Silver wasn't the only statistician calling Obama's victory months ahead of time. Princeton Election Consortium, Votamatic.org and FrontloadingHQ predicted the electoral outcome accurately.
What does any of this have to do with investing?
Several decades of studies by behavioral economists show that we hamstring ourselves when it comes to investing. We are hopelessly prone to overconfidence. We make judgments based on what we've heard or seen most recently rather than long-term history. (Noonan, anyone?)
We're susceptible to something called confirmation bias. That's when we seek out information that confirms our pre-existing beliefs.
Thus the Romney victory predictions by conservatives Dick Morris, George Will, UnSkewedPolls.com and Karl Rove, who refused on TV even late Tuesday to accept Fox News' projection of an Obama win. But liberals are susceptible, too.
Some fund managers and their salespeople take advantage of our shortcomings. They throw all sorts of predictions and data at us. They hawk active trading strategies they say can "beat the market."
But their long-term, aggregate performance data consistently tell another story.
Over time, investing in a diversified set of stocks pays off. Over time, Wall Street managers who try to beat the market won't.
Rick Ferri, founder of investment firm Portfolio Solutions in Troy, Mich., has examined these broad mutual fund returns over decades. He's found that over just about any five-year period only 25 percent of stock mutual funds beat their comparable market index. They beat their index, on average, by 1 percent a year.
Fifty percent fail to beat the market. They underperform by 2 percent a year, on average.
The remaining 25 percent? They simply go out of business at some point in those five years, most likely because they were performing poorly.
That means for any actively managed mutual fund, "the probability of beating the market is about 25 percent," Ferri said.
The latest S&P Dow Jones Indices scorecard bears this out. Over a five-year period through June, two-thirds of all U.S. stock funds failed to beat the Standard & Poor's Composite 1500 index, it reports. That index tracks the largest publicly traded companies listed on the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600 indices.
In only one stock fund category -- large-cap value -- did more than half the managers consistently beat their market index. But over the past three years, 77 percent of those managers have underperformed, S&P says.
"You might see a few active managers where you could actually say they had skill," said Ferri, who's written a book on passive investing. "The problem is that's in the past. Now looking forward, how do you determine which managers are going to outperform?"
It's harder than you might think. Funds that outperformed in the past tend not to do so in the future, research has shown. That's partly because investors start piling money into the fund. Larger amounts of money force managers to change how they invest. Ultimately, their results suffer.
Fear not. For you, the average investor, there's great comfort in all this. The safest thing you can do is invest passively instead of actively.
How? Invest using low-cost index funds and exchange-traded funds that closely track a market index. That would be, for instance, a fund tracking the S&P 500 index for large-company stocks or one tracking the Barclays U.S. Aggregate Bond Index for bonds. The Vanguard Group Inc., Charles Schwab & Co. Inc., BlackRock's iShares and State Street Corp.'s SPDRs offer the best options.
Using these you'll come close to mirroring the results of every other trader out there. And you'll end up doing better in the long run.
"After all, any investor can do as well as the average investor with almost no effort," Silver writes in his book, recommending index funds. "You have to be really good -- or foolhardy -- to turn that proposition down."
Distributed by MCT Information Services
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