If You Use Active Managers, Diversify Them

(MoneyWatch)  As we discussed in Monday's post, if you invest in passively managed vehicles such as index funds, there is no need to diversify money managers. If one family of funds provides the best vehicles, you should use their funds since there's no benefit to diversifying managers. On the other hand, if you invest in actively managed funds, diversification will reduce risk.

Collectively, active managers earn the same returns as passive investors. This means that (before considering fund expenses) you are just as likely to pick an underperforming fund as an outperforming fund. By diversifying your active managers, you become less likely to face an overall large loss. (It's important to note that you also reduce the chance of an exceptionally large gain.)

Consider the following example from my friend Bill Schultheis, who writes the blog The New Coffeehouse Investor based on his book of the same title. This example is also in my book Wise Investing Made Simple.

Outfoxing the Box
If you invest in actively managed funds, you have the hope of outperformance. However, in return you must accept the risk that your manager will underperform. The table below contains nine percentages, each representing the rate of return a money manager is guaranteed to earn going forward.

0%	5%	23%
6%	10%	14%
-3%	15%	20%

You have the following choice: You can either accept the 10 percent rate of return in the center box or you will be asked to leave the room, the boxes will be shuffled around, and you will have to choose a box, not knowing what return each box holds.

You quickly calculate that the average return of the other eight boxes is 10 percent. If thousands of people played the game, the expected average return would be the same as if they all chose not to play. However, some would earn -3 percent per year, while others would earn 23 percent per year.

This is like the world of investing, where if you chose an actively managed fund and the market returns 10 percent, you might be lucky and earn as much as 23 percent per year. However, you are just as likely to be unlucky and lose 3 percent per year. A rational, risk-averse investor should logically decide to "outfox the box" and accept the average (market) return of 10 percent.

In my years as an investment advisor, I have never once had an investor choose to play when I've presented this game. Everyone chooses to accept "par," or 10 percent.

The only reason that investors choose to play the game with actively managed funds is that they are overconfident of their abilities to identify the few active managers that will succeed. Unfortunately, overconfidence is a very common human trait.