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
