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In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Today, they discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this tenth series, they discuss mistake number 18: Do you believe your fortune is in the stars? And mistake number 19: Do you rely on misleading information?
LEARNING: Stop thinking about having your fortune in the stars. Avoid actively managed funds. Be cautious when evaluating claims about fund performance.
“Stop thinking about having your fortune in the stars. Morningstar won’t help you.”
In today’s episode, Andrew continues his discussion with Larry Swedroe, head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today Andrew and Larry discuss a chapter of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this tenth series, they discuss mistake number 18: 18: Do you believe your fortune is in the stars? And mistake number 19: Do you rely on misleading information?
Did you miss out on previous mistakes? Check them out:
- ISMS 8: Larry Swedroe – Are You Overconfident in Your Skills?
- ISMS 17: Larry Swedroe – Do You Project Recent Trends Indefinitely Into the Future?
- ISMS 20: Larry Swedroe – Do You Extrapolate From Small Samples and Trust Your Intuition?
- ISMS 23: Larry Swedroe – Do You Allow Yourself to Be Influenced by Your Ego and Herd Mentality?
- ISMS 24: Larry Swedroe – Confusing Skill and Luck Can Stop You From Investing Wisely
- ISMS 25: Larry Swedroe – Admit Your Mistakes and Don’t Listen to Fake Experts
- ISMS 26: Larry Swedroe – Are You Subject to the Endowment Effect or the Hot Streak Fallacy?
- ISMS 27: Larry Swedroe – Familiar Doesn’t Make It Safe and You’re Not Playing With the House’s Money
- ISMS 29: Larry Swedroe – The Shiny Apple is Poisonous and Information is Not Knowledge
Mistake number 18: Do you believe your fortune is in the stars?
According to Larry, people are still relying heavily on Morningstar ratings. When Morningstar increases its rating, cash tends to flow in, and money flows out when it lowers its rating. Morningstar’s ratings, similar to film critics’ ratings, are widely used by investors to determine fund performance and which funds to invest in.
However, these ratings are not a reliable way to choose your investment. Even Morningstar eventually reported in a study that they found that the fund’s expense ratio was a better predictor than Morningstar’s ratings. According to Larry, that’s precisely what you would expect if markets are efficient, which means that good stock pickers can’t exploit the market.
So, people who rely on Morningstar ratings are just fooling themselves. There’s no informational value in Morningstar’s rating system.
Larry says that investors are best served by simply avoiding actively managed funds. Choose the asset classes you want to invest in, then do some research. Look for low-cost funds/instruments that give you the most exposure per unit of cost. Stop thinking about having your fortune in the stars. Morningstar won’t help you. Neither will an advisor who’s recommending actively managed funds.
Mistake number 19: Do you rely on misleading information?
In this chapter, Larry discusses the issue of misleading information in the investment industry, particularly concerning mutual fund returns, and highlights two biases that distort reported returns.
According to Larry, survivorship bias is where poorly performing funds disappear over time through mergers with better-performing funds. However, the reported performance of the merged funds doesn’t reflect the poor returns of the disappearing funds. This bias leads to an overestimation of average fund returns, as demonstrated by an example from 1986 to 1996, where the disappearance of underperforming funds led to an apparent improvement in overall returns.
Larry mentions a second bias, incubator funds. These are newly created funds that mutual fund families seed with their capital and keep away from public scrutiny. Fund companies often bring public only the fund with the best performance from a group of incubator funds, effectively hiding the underperforming ones. The SEC’s allowance for not reporting the pre-public performance of incubator funds leads to potential distortions in reported returns. Examples of abuse, such as allocating hot initial public offerings (IPOs) to small incubator funds to enhance their returns, further exacerbate this bias.
Larry recommends prohibiting advertising returns before a fund is available to the public. This could help mitigate the potential for biased reporting. Additionally, he advises investors to be cautious when evaluating claims about fund performance and to ensure that reported data doesn’t contain the two biases he’s mentioned.
About Larry Swedroe
Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.