Can you really trust investment results?
I recently read How Not to Be Wrong: The Power of Mathematical Thinking by Jordan Ellenberg and while my wife still thinks I’m wrong quite a bit (I disagree of course!) the book contained a great story that should act as a cautionary tale to all investors.
Baltimore Stock Picker
In one of the many stories about how probabilities can be used against us, Ellenberg recounts what he calls the Baltimore Stock Picker. In essence the story goes that an investment advisor sends out a mailing to a vast number of potential clients, half of which he recommends to buy a stock and the other half to sell it.
Since stocks either go up or down, he is bound to be correct on half of the recommendations. The advisor then sends another recommendation to the half that received the good tip. Again, he tells to buy and other half sell.
This continues for a few more recommendations until the advisor has a small group that have received multiple correct recommendations in a row. This group is so amazed with the investing prowess of the advisor that they are more than willing to pay him to manage their portfolio full time. Little do they know that the advisor really isn’t good at picking stocks and they were just the unlucky ones to be sent correct guesses each time.
For each person who received a handful of correct picks in a row, there are countless others that got the wrong pick and don’t see the advisor as a stock picking savant.
When Numbers Turn Against Us
The power of this idea, that probability and math can be used to trick us, really stuck with me. When you think about it, data is skewed all the time to suit the needs of the user. What the Baltimore Stock Picker story reminds us is that when it comes to investing, if it seems too good to be true, then it probably is. Next time someone tells you about a great stock pick they had, ask yourself how many they have gotten wrong.
Beware Amazing Returns
This can be true with new mutual funds. Typically new mutual funds are started in groups. They then battle it out internally before the fund is opened up to outside investors. Kind of like the Battle Bots of finance. Since the mutual fund companies have a variety of funds, based on sheer probability, chances are one will make enough correct picks to show a good return that can be advertised to attract new investors. This is the fund that is ultimately opened to the public. Now while the fund may actually have a great manager that will continue to grow the fund long term, there is also the chance that they just got lucky early on and that they won’t be able to achieve such a high return going forward. That’s why I recommend not investing in new mutual funds. Wait until they have a few years of history to prove they can deliver consistent returns before investing.
So be alert and remember not to take everything at face value. When dealing with your money, it’s easy to be emotional and jump at investments offering eye popping returns or to be swept up by a stock picking genius. However, in reality there is always more than meets the eye. So if it sounds too good to be true, take some extra time to really review the investment before making a decision.