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Sunday, March 4, 2012

Flipping Pennies

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


  1. I always find it to be a useful exercise to go back and look at the stocks or funds that the money magazines recommended ten years ago as being the sure fire investments for the next decade. It is usually a list of fad stocks and funds that perform pretty poorly over the next decade.

  2. I agree. In fact, at this moment it is a coin toss when you think of two really smart people like Jeremy Siegel and Robert Shiller offer very different views of the market. These two are a heck of a lot smarter than most of the "hot" fund managers out there.

  3. Buffett had an interesting response to this coin-flipping metaphor in a speech he gave at Columbia back in the 80s called "The Superinvestors of Graham-and-Doddsville".

    Here is a link:

    However, in my experience, the actual data from the mutual fund industry matches the original metaphor very closely. Past out-performance is unlikely to persist into the future, so keeping costs low and maintaining broad diversification through indexing is likely to be the best strategy.

    1. Thanks for the link. I had not seen that speech. I will read it carefully. Buffett's thoughts are always interesting.

  4. My epiphany was when I realized the difference between returns and annualized returns!

    I lived through the dotcom era when fund managers boasted enormous returns riding the wave and lost twice as much when the wave ended. There is no skill in that.

    1. Games can definitely be played with return calculations!