We often read about funds that have outperformed the market, or, to use a technical term, delivered alpha. But investors always need to ask… A video on the Bloomsbury Wealth YouTube Channel.
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Transcript: Robin Powell & Mark Hebner/ Author & indexing advocate
RP: We often read about funds that have outperformed the market, or, to use a technical term, delivered alpha. But investors always need to ask: Is that fund’s performance statistically significant? In other words, how sure can we be that it resulted from genuine skill and not just random chance?
MH: What people don’t pay attention to. You don’t see it in Morning Star or Leper or any of the services that track mutual funds is the variability of that alpha. So one year they made 5% and then they went 3 or 4 years -1% to the benchmark. Right. But that one year with the five or even higher, maybe 10% was their lucky outcome. And even though they had multiple years after that earning what they should earn, which is below market returns, it appears that they had six years of great performance.
RP: In investing, distinguishing between what statisticians call a chance outcome and a systematic outcome is very complicated. Only a small proportion of financial advisers, let alone investors, have the statistical know-how required to even attempt it.
MH: It’s what I call the language of risk. Risky. You have to speak this language to fully understand it. And just like legally is, you know, if you don’t know all the legal language, you probably shouldn’t be representing yourself in court. Well, if you don’t speak risky, you shouldn’t be representing yourself in the public markets, okay? You have to have a better understanding or hire somebody who understands these statistical principles. And I think that’s probably the number one problem for people as investors is they just want to rely on their gut. And then instead of at least a reasonable knowledge of statistics.
RP: But of course, this is not to say that all statistics are misleading. As Mark Hebner explains, the data contained in peer-reviewed academic research are generally the most reliable.
PR: An academic paper has a series of what are called referees that check these statistics before, an academic is able to publish the paper. It is. It goes through a rigorous test and checking by other academics before it can be published. That’s peer-reviewed research. Huge. Huge idea. These things have been tested and checked by other almost competitor academics. These academics are competing really to publish, you know, really high-quality research. And so nobody no academic wants the other academic to get away with data mining. Small sample sizes, non statistically significant data.
RP: In short, if you don’t understand statistical significance, you really shouldn’t be choosing actively managed funds. Ideally, find yourself an adviser who does understand it and who does have a good grasp of academic finance.
Disclaimer — The information in this video does not constitute advice or a recommendation, and you should not make any investment decisions on the basis of it. If you do however require advice please do not hesitate to contact Bloomsbury Wealth.
