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What the election teaches us about investing

(MoneyWatch) There was a clear winner in the recent presidential election. That winner, by a landslide, was Nate Silver, statistician and New York Times blogger of the blog. As a self-proclaimed math geek, I was fascinated and found myself checking in with his web site frequently leading up to the election, and was glued to it the whole evening of the election. When the election dust settled, the realization dawned that Silver had managed to call all 50 states correctly. He forecast that Obama would win by a popular vote margin of 2.5 percent, right where it is as of the time of this writing. That is nothing short of remarkable in my math-geeky book.

Which begs the question that has been discussed almost as much as the results of the election -- how the heck did Silver do it? As his book title "The Signal and the Noise" suggests, Silver ignored the noise other forecasters were focused on. So while other prognosticators concentrated on gut feeling and what other experts were saying, Silver focused on the statistics. He knew that most polls reported results within the margin of error, but he could deduce that a much larger sample size of all of the polls showed a very clear cut probability that President Obama would be reelected. Silver noted that the polls as a whole would have had to be biased for Romney to prevail. His conclusion was based on statistics and probabilities, not emotions.

So what does this have to do with investing? Plenty. It's the same unemotional detail to probability and statistics that will prevail. Though I wasn't able to reach Silver, I'm guessing he would tell me that the probability of 90 percent of investors beating the market is zero. (Only half of investors can be above average.) And 90 percent of money invested in stocks is professionally managed or advised.

Next we must consider probabilities. The data show that 42 percent of the active funds or separately managed accounts will beat the comparable broad low cost index fund in a given year. Those odds aren't that bad, in fact they are much greater than the odds Silver gave Romney.

But we don't typically have one fund for one year. We often own 10 or more funds and invest for 25 years or longer. In each case, stock pickers or bond managers buy the securities they think will outperform. But the more funds or managers you have and the longer you invest, the worse the odds get. You can see the odds I calculated in the table below.

Owning 10 active funds over a 25 year period gives you well under a one percent probability of beating the unemotional choice of an index portfolio that simply owns all the stocks or bonds in a given index. Or put another way, the typical professionally managed portfolio has a 99 percent probability of failing versus the index approach.

To place that in election perspective, consider that the day before the election, Nate Silver gave Romney a 9.1 percent chance of winning the election. That's more than nine times the probability of active beating the passive indexing approach in the long run. Which leads me to my conclusion: Do you feel lucky? You decide whether you want to bet on you being incredibly lucky, or to bet on probabilities and statistics.   

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