If you are reading some list of the "top 5 funds" of the decade or listening to some investment manager on CNBC boast about how his fund outperformed the market over the last decade, remember the "flipping pennies" metaphor.
If we take 100 people and have them flip a penny, approximately 50 will have heads. Let those 50 flip again and approximately 25 will have heads. Repeat for the 25 still standing and we have approximately 12. Repeat once more and we have 6 standing. These are the "best" penny flippers.
This simple metaphor shows that pure luck will statistically produce winners from a group that attempts a difficult task. Here the task is to get 5 heads in a row. The odds are very slim that you will get it; but, if we do it with 100 people, the odds are good that a few will get it. Worth thinking about. Think about how many actively managed mutual funds are out there charging high fees.
The task in the investment world is to get outstanding performance over the long run when you are subtracting fees on an annual basis ranging between 1.5 and 2.5% and, in some egregious cases, even higher.
But the best part of the pennies metaphor is the follow up question: if we want to pick people out of the 100 who are superior coin flippers in the future, would we pick the winners from the initial experiment? This is what people do when they sit in a human resources meeting and pick funds with the best track record for their 401(k). For sure, they may pick someone with such awesome talent that they outperform their fees. The evidence from numerous studies, however, shows this is unlikely. Out of the top 10 funds from the past 10 years, only 2 or at most 3 will outperform the market over the next 10 years. That's what the evidence shows.
Unfortunately the simple pennies flipping metaphor is not well known, and people invest their retirement funds with the "market beaters" of the past. And it is costing them!
Fred Schwed Jr. - Where are the Customers' Yachts? or A Good Hard Look at Wall Street