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Coin Flips

Last week I participated in an adult trivia night. I have never had a better time feeling so dumb. They say you learn something new every day. Turns out, I could stand to learn a bunch more new things.

Every year at trivia night, they play a game. It’s called Heads or Tails. Everyone stands up and pulls a dollar out their pockets. They place the dollar either on their head or on their backside. A coin is then flipped. If your dollar rests in the same spot indicated by the coin flip – heads or tails – you survive to the next round and get to guess again. If not, you lose your dollar and have to sit down.

It’s a simple game. And yet it can be instructive when thinking about your investment portfolio.

I’m always amazed by how many rounds of Heads or Tails people will survive at trivia night. Often, it takes five, six – maybe even seven – coin flips before there is just one person still standing in the room. That’s a lot of good guessing.

But think about it. It should not be surprising at all. If you do the math, the odds of guessing one round correctly is 50-50. So after the first round, approximately half the people will sit down. The probability of guessing two rounds correctly is 25%. Three rounds – 12.5%. Four rounds would be a little more than 6%. The math is easy.

Let’s say there were 225 people at trivia night. By random chance – pure luck – math tells us that there is a 0.78% probability of guessing seven coin flips correctly. Multiply that by 225 and you get 1.76. In other words, just more than one person should have guessed the right sequence of flips after seven rounds.

So in fact, I should not be surprised at all that it sometimes takes five or six rounds to get just one person still standing. By chance alone, it should take seven or eight rounds every single time.

There’s an interesting connection between the Heads or Tails game at trivia night and selecting investments, believe it or not. First, let me supply a little context.

Broadly speaking, there are two camps when it comes to investing. The first camp tries to beat the market. They attempt to buy the right companies at the right time and avoid the poor performing companies. We call this camp “active” managers. They actively try to beat the market.

The second camp simply tries to match the market. They do not try to buy the right companies or avoid the wrong companies. They just buy them all and hold them in the same proportion they represent in the market. If Coca-Cola’s stock makes up 1% of the market, they try to hold just 1% of Coca-Cola. This camp is called “passive” managers. They do not make active decisions, they passively track the market.

Here’s an easy way to think about it. If the market is up 6% in a given year, an active manager hopes to generate a return greater than 6%. A passive manager hopes to earn right at 6%.

Most people probably ask, “Why wouldn’t I want an active manager? Isn’t it better to beat the market?” And the answer is yes, it would be better. But just because active managers try to beat the market does not mean they are always successful at doing so.

Fortunately, we have a long history of investment performance for active managers. We know exactly how often they outperform the market. The results are fascinating – or frightening, depending on your perspective.

Over any 10-year period, active managers beat the market roughly 15% of the time. If there are 1,000 active managers, 150 of them do what they set out to do. The other 850 perform worse than the market. If you selected one of the 850 funds that underperformed, you would have been better off with a passive manager, who simply matched the market’s performance.

It gets even more interesting, though. Let’s say we were lucky enough to pick one of the 150 active managers who outperformed over the first 10-year period. By random chance alone, we would guess 38 of those 150 funds would outperform in the next 10-year period. But the actual data show something different. In reality, only about 28 of the funds outperform over the next period.

The amazing conclusion is that you and I have no better odds of picking the investment fund that will outperform in the future as we do guessing whether to place a dollar on our heads or backsides. In fact, our odds are slightly worse at picking the right fund.

As investors, most of us would be better off with a passive manager that just tracks the market, rather than trying to beat the market. That’s not a sexy approach to investing, but it’s an approach that limits the chance of feeling dumb by choosing an active manager that underperforms.

You can have a great time feeling dumb at trivia night. The feeling isn’t the same, though, when it comes to your investment portfolio.

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