More often than not, you’ll hear about people beating the market or otherwise doing really well. But a lot of them are misleading and/or overstated. Here’s why.
People are more likely to report great returns than crappy ones
Most people have egos and/or want themselves to look good. If their investment returns suck, then they are highly likely to keep their mouth shut because they don’t want to look dumb.
Sometimes, it’s in the speaker’s self-interest to promote themselves or their companies. And it’s almost always that case that behaviour follows incentives.
Here are some ways to overstate returns.
Suppose you flip a coin 10 times and it lands heads 5 times and tails 5 times. The first two flips are tails. So, you start counting from the third flip. Lo and behold, your coin flipping record is 5 heads and 3 tails. It gives the impression that you’re good at flipping heads. But the actual track record (5-5) is simply average.
Mutual funds do this by reporting the 3-month, 1-year, 3-year, 5-year, 10-year, since inception, etc. return… whichever happens to be better. If a mutual fund really stinks it up, it will usually end up being merged or shut down. Which leads us to…
If all the poor/unlucky performing mutual funds are taken out, then the survivors will be stacked towards having good track records. So you end up with a world where it looks like most mutual funds are able to “beat” the market. But this might not be the case. (The reality is that most mutual funds charge way too much in fees. On average, they will lag the market a lot because of these fees.)
Not actual returns
Sometimes people report returns based on backtesting historical data. It’s not based on actual returns. The problem with backtesting is that it often suffers from data mining. If you look at enough data, you will find correlations that won’t predict the future. For example, if you categorize stocks based on the first letter of their name, you will find that some letter will outperform all others. However, a company’s name will have little to do with how well that company will perform in the future.
Simply lie about it
Some people like Bernie Madoff just make stuff up. Is this really news?
My investment returns 😉
2008-2009 combined +22.1%
Yes, my penis is bigger than yours*.
(*Just kidding. It probably isn’t.)