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Investing Basics

Active Trading: Skill or Luck?

Baby Boomers worried about running out of money in retirement are changing tack, actively trading on 401(k) accounts and IRAs in an attempt to boost returns, according to an article in the LA Times.

Articles by Betterment Editors

By the Editorial Staff
Betterment Resource Center  |  Published: July 16, 2012

Buy and hold is the favored approach for the average American saving for retirement, with less than 15% making changes to their 401(k) accounts last year, the article said. But among those who are willing to make changes to their accounts, active trading is picking up in pace. The article references anecdotes from a number of individual investors and financial planners as evidence of this.

I’m uncertain if the trend is as widespread as the article suggests – but if it is, it’s a huge concern. The average investor underperforms the fund they invest in by half; a widely cited DALBAR study shows.

Extraordinary Returns

So what of the professionals? Hedge funds are the most active of actively managed funds and are capable of producing extraordinary returns for the wealthy clients they serve. John Paulson was the head of such a fund – his flagship fund, Advantage Plus, was up 150% at the end of 2007 (yep that is a zero on the end!).

But – and it’s a huge but – with great reward comes great risk, something Paulson is familiar with. At the end of last year, the same fund was down 52%.

There are a number of reasons given for Paulson’s down-fall: overconfidence in the American economy, underestimating the European crisis, the difficulty of maintaining rate of return in hedge funds when they grow ($7billion up to $30billion under management), and the fact that the best calls are made before the money pours in – people invest billions after hearing about extraordinary returns, by which point it’s too late to reap the rewards.

Luck Versus Skill?

Professor Eugene F. Fama of the University of Chicago Booth School of Business claims that the success of actively managed funds like Advantage Plus is sheer luck.

Fama and his colleagues demonstrated that “only the top 3% of managers produce returns that indicate they have sufficient skill to cover their costs” (meaning that only 3% produce extraordinary returns after fees).

But 3% is nothing special, Fama says: “Taking three or four thousand funds, you expect the top 3% to look good – that is the luck versus skill part of it – which means that the other 97% look worse.”

Fama details the results of the study in this brief video.

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