Last Updated Jul 9, 2010 2:19 PM EDT
Streaks randomly occur with much greater frequency then people believe. For example, your odds of flipping a coin 20 times and getting either four heads or four tails in a row are 50 percent. Because people underestimate the frequency of streaks, they tend to assign far too much meaning to events that are highly likely to be random occurrences.
A common investment error is to jump on the bandwagon of an actively managed fund that has beaten its benchmark a few years in a row. You may perceive there's a causal relationship when the performance is far more likely to be random.
Consider the case of the 44 Wall Street Fund. It ranked as the top performing diversified U.S. stock fund of the 1970s, even outperforming Peter Lynch's Magellan Fund. However, 44 Wall Street ranked as the single worst performing fund in the 1980s, losing 73 percent while the S&P 500 Index grew at 17.5 percent per year.The fund did so poorly that it was merged into the Cumberland Growth Fund in April 1993, which was then merged into the Matterhorn Growth Fund in April 1996.
Now consider the case of the Lindner Large-Cap Fund. It outperformed the S&P 500 every year from 1974-84. However, investing on that track record meant several years of underperformance, as the S&P 500 soundly beat the fund over the next 18 years, returning 12.6 percent to the Lindner Large-Cap Fund's 4.1 percent. The Lindner Fund was finally put out of its misery when it was purchased by the Hennessy Funds in October 2003 and eventually merged into the Hennessy Total Return Fund.
And then there is the case of Bill Miller's Legg Mason Value Trust, which beat the S&P 500 Index 15 years in a row. And then delivered miserable performance over the next several years.
Another example would be Julian Robertson's Tiger Fund, formed in 1980 with $8 million in capital. The fund had a remarkable run, averaging a gross return of 36 percent per year for the first 18 years. By 1998, it had excess of $22 billion under management; the vast majority coming from new investments. However, the fund dropped to about $8 billion by December 1999. The irony is that while the fund still showed a return of 27 percent per year over its life, investors in the fund may have actually lost money.
These tales demonstrate that 10, 11 or even 18 years of outperformance are not sufficient to draw reliable conclusions. This type of evidence is why the SEC requires its disclaimer on past performance and why the American Law Institute concluded: "Evidence shows that there is little correlation between fund managers' earlier successes and their ability to produce above-market returns in subsequent periods."