In part 1 , I explained why the average professional money manager doesn’t get better returns than the stock market averages. Once we take into account the high costs charged by professional money managers, we find that index funds beat most actively-managed mutual funds. However, it is possible to find analyses within the mutual fund industry that seem to contradict these conclusions. This is because mutual fund lists contain only those funds that are still active. Poorly-performing funds get closed or merged with other funds . Wouldn’t it be nice if we could all throw out our worst performances? “Judge, I’d like to point out that that in 3 out of 5 football games I attended this year, I didn’t go streaking onto the field.” If we calculate average mutual fund returns after throwing out bad funds, we get an artificially inflated average return that is higher than the returns investors actually received. This is called survivorship bias. In the book “A Random Walk Down Wall Street...

Actively-managed mutual funds have professional money managers who can do a better job of investing than the rest of us, right? That’s not what the evidence says. Studies show that the average professional money manager does not get better results than the market averages. There are a number of reasons for this including the difficulty of investing very large sums of money and the pressure to show decent results every quarter or face having investors leave the mutual fund. The simplest reason, though, is that professional money managers control so much of the total money invested in stocks and bonds that they dominate the averages. The US Federal Reserve’s December 2007 statistics contain a breakdown of stock holdings in Table L.213. It is not immediately obvious which line items correspond to professional money managers, but if we include just state and local governments and their pension plans, insurance companies, private pension funds, mutual funds, closed-end funds, and exchan...

Lee Valley Tools Ltd. has initiated a class action suit against Canada Post over shipping charges. Before 7 years ago, Canada Post charged for shipping packages by weight. Then they introduced a new system where they charged for either weight or volume depending on which gave the higher charge. The idea was to charge more for big bulky packages that take up a lot of space, but aren’t very heavy. This all sounds reasonable enough, except that Lee Valley alleges that the machine Canada Post uses to measure volume can overstate the volume by as much as 20%. Another allegation against Canada Post in all this is that they keep any overpayments. Commercial customers have to weigh their packages and calculate the charges themselves. If Canada Post finds that the customer paid too little, they demand more money, but if the customer pays too much, Canada Post keeps the difference. Nice. If Canada Post loses this suit, it could be very costly for them. Of course, if Canada Post loses and ...

You may have heard of risk-adjusted returns in connection with mutual funds. The basic idea is that a risky investment may not be better than a predictable investment even if the risky investment has a higher expected return. There is some validity to this, although it is too often used to justify the poor returns of mutual funds compared to the overall stock market. Normally, any discussion of risk-adjusted returns includes some intimidating math. I’ll explain the problems with risk-adjusted returns without needing the math, and I’ll give pointers to where the math can be found for those who are interested. According to the theory, before comparing investments, you should do a risk-adjusted return calculation that will reduce the returns according to how risky they are. The riskier they are, the more the returns are lowered before any comparison. By “risk” here, we mean volatility, which is a measure of how much the returns vary over time. An investment that grows steadily has low...

Wouldn’t it be great if you knew when the stock market was going to go down? You could sell your stocks, wait for a while, and buy them back when the stock market was going to rise again. You’d get rich very quickly. Sadly, there doesn’t seem to be any magic way to know when the stock market will go down. You just can’t predict short-term swings in stock prices. But the sting of watching the value of your holdings drop 10% can make it tempting to look for signs of a market decline. Many people actually do a reverse kind of market timing. They get nervous and sell after stock prices drop, and they buy back in after prices start to rise again. Many commentators offer the sound advice that you should keep saving money and ignore short term stock market swings. Suppose that you have taken this advice to heart. Maybe you pour savings into low-MER index funds every month without thinking about whether stocks are up or down. Even so, you will still be forced into a situation whe...

Most commentators agree that people should be investors rather than traders. However, it’s impossible to be an investor without trading sometimes (or at least once). This is like telling people not to become smokers, but expecting them to take a puff once in a while. Let me start by explaining what I mean by “trader” and “investor.” A trader is someone who buys and sells stock. We usually use the term “trader” to mean those who trade stocks frequently and base their decisions on recent stock price movements rather than the health and future prospects of the businesses behind the stocks. An investor is someone who examines businesses to try to predict their long term success in terms of revenues and profits. Some commentators stop there, and I know what they mean, but none of this analysis makes any difference unless you actually buy the stock. Investors have to be traders at least part of the time. Let’s say that you are an investor who has found a business you would like to...

Happy new year! I have a few fearless predictions for the upcoming year. 1. Half of all financial prognosticators will correctly guess whether the stock market will go up by more than usual this year. Of course, the other half will get it wrong. Maybe we would be better off if we ignored people who pretend to know what is going to happen to stock prices in the short term. 2. Interest rates will either go up, or down, or stay the same. This is a safe one. Some people will pick just one of these three possibilities, but I don’t believe they know what will happen to interest rates any better than the rest of us. I doubt that even the people who set interest rates know for certain what they will do more than a few weeks in advance. 3. Newspapers will continue to print explanations for what happened in the stock market each day. We see articles with titles like ‘markets jittery amid inflation concerns’ or ‘market rally blunted by corporate earnings pessimism.’ I rarely find these expla...