year edge—an ultimatum: that he will be fired if he does not at least match
the market after two years. Table 20-2 shows that the probability he will
beat the market over two years is only 74.8 percent. This means there is al-
most a one-in-four chance that he will still underperform the market and
you will fire Lynch, judging him incapable of picking winning stocks!
Persistence of Superior Returns
Do some money managers have “hot hands,” meaning that if they out-
performed the averages in the past, they are likely to do it again in the
future? The conclusions of numerous studies are not clear-cut. There is
some evidence that funds that outperform in one year are more likely to
outperform the next.^7 This short-run persistence is probably due to the
fact that managers follow a particular “style” of investing and styles
often stay in favor over several years.
But over longer periods, the ability of fund managers to continue to
outperform the market finds less support. Elton, Gruber, and Blake
claim that outperformance persists over three-year periods,^8 but Burton
Malkiel, Jack Bogle, and others disagree.9,10In any case, performance can
change suddenly and unpredictably. Perhaps Magellan’s underperfor-
mance after Peter Lynch left the fund did not surprise some investors.
But Bill Miller’s hot hand with Legg Mason’s Value Trust, which
recorded a record 15 consecutive years of beating the S&P 500 Index,
suddenly and unexpectedly turned cold in 2006 and 2007.
REASONS FOR UNDERPERFORMANCE OF MANAGED MONEY
The generally poor performance of funds relative to the market is not due
to the fact that managers of these funds pick losing stocks. Their perform-
ance lags the benchmarks largely because funds impose fees and trading
costs that are often as high as 2 percent or more per year. First, in seeking
superior returns, a manager buys and sells stocks, which involves broker-
age commissions and paying the bid-ask spread, or the difference be-
348 PART 5 Building Wealth through Stocks
(^7) Darryll Hendricks, Jayendu Patel, and Richard Zeckhauser, “Hot Hands in Mutual Funds: Short-
Run Persistence of Relative Performance, 1974–1988,” Journal of Finance, vol. 48, no. 1 (March 1993),
pp. 93–130.
(^8) Edwin J. Elton, Martin J. Gruber, and Christopher R. Blake, “The Persistence of Risk-Adjusted Mu-
tual Fund Performance,” Journal of Business, vol. 69, no. 2 (April 1996), pp. 133–157.
(^9) Burton G. Malkiel, A Random Walk Down Wall Street, 8th ed., New York: Norton, 2003, pp. 372–274.
(^10) John C. Bogle, The Little Book of Common Sense Investing, Hoboken, N.J.: Wiley, 2007, Chap. 9.