High school students figure out early on when there is a penalty for guessing on a standardized test. They have a strategy to determine when to guess and when to leave the question alone. This simple test-taking skill can impact the colleges that consider them and the scholarships they receive.
It’s too bad most investors don’t understand that investing in managed funds is a lot like choosing “C” for all the questions on the SAT. Except in this case the final exam is retirement planning. You’ll get it right sometimes, but most of the time you’ll be disappointed.
This isn’t just a cute comparison. The probability of “C” being the correct answer is 20 or 25 percent on a pure guess. That’s a little worse than fund managers do making their “educated” guesses. Compounding the problem to the absurd is the fact that investors must guess which manager is the best guesser. The probability of picking a fund that will beat the index in that scenario drops fast.
An educated guess is possible if you can get rid of the obviously bad choices. By eliminating A, B, and E from the options, you’re left with C and D and a 50/50 shot at getting it right. Researchers at Capital Research found that there are a small group of managed funds that pull this off, but they rely heavily on low costs. Since low costs are already available with index funds and brokers would prefer to sell you something that pays better, it hardly seems worth the effort.
The required effort, by the way, is increasing. Beating the market means beating the average investor. Since the average investor is savvier than ever, that bar is a tough one to clear.