Efficient Markets - Picking Winners By Past Performance

On Sunday, the Buffalo Bills advanced to the AFC Championship Game, putting them one win away from their first super bowl appearance in 28 years. A big reason for the Bills long drought was this man, Tom Brady.  

As much as it hurts for me to say this as a Bills fan, Tom Brady is arguably the greatest quarterback of all time.  In the years he played for New England, he racked up 17 division titles and 6 superbowls.  Between 2009 and 2019, the New England Patriots won the AFC east ever single year – 11 times in a row.  If you picked a year during their title run between 2009 and 2019, the Patriots were consistently the favorite to win the division.  As good as Tom Brady was, the other teams in the division (the Bills included) weren’t fantastic.  

If you were into gambling and wanted to pick a winner, the odds were that the Patriots were going to win and you would have done well by simply picking the Patriots.

So, what does this have to do with investing?

In my last video I explained that only a small number of actively managed mutual funds beat simple index funds over long periods of time.  So, how do most people go about picking an active mutual fund?  Naturally, they look for funds that have been successful in the past and expect that they will continue to outperform their peers in the future.   That is, after all, how a lot of other things work.  To pick winners, we select people or products that have been successful in the past.  

But, the data tells us that this is actually a really bad way to pick mutual funds.  In the years between 2009 and 2019, if you picked only the top 25% of funds in the previous 5 years,  only 21% of global equity funds went on to continue to outperform, and 29% of global fixed income funds went on to outperform.  That means if you simply picked the previous winner, expecting it to continue to be a winner in the future, you had basically a random outcome over the next 5 years.  

Why is this the case?

A lot of the reason is that, again, markets are very competitive and efficient.  It is difficult to outperform a simple broad market index fund over long periods of time.  And, since past performance is not an indicator of future results, picking solely from a basket of winners doesn’t get you any further.