that they will exceed the average market return after 30 years. If man-
agers pick stocks that will outperform the market by 2 percent per year,
there is still only a 72.8 percent chance that they will outperform the
market after 10 years. This means there is a one-in-four chance that they
will still fall short of the average market performance. The length of time
needed to be reasonably certain that superior managers will outperform
the market will most certainly outlive their trial period for determining
their real worth.
Detecting a bad manager is an equally difficult task. In fact, a
money manager would have to underperform the market by 4 percent a
year for almost 15 years before you could be statistically certain (defined
to mean being less than 1 chance in 20 of being wrong) that the manager
is actually poor and not just having bad luck. By that time, your assets
would have fallen to half of what you would have had by indexing to
the market.
Even extreme cases are hard to identify. Surely you would think that
a manager who picks stocks that are expected to outperform the market
by an average of 5 percent per year, a feat achieved by no surviving mu-
tual fund since 1970, would quickly stand out. But that is not necessarily
so. After one year there is only a 7-in-10 chance that such a manager will
outperform the market. And the probability rises to only 74.8 percent that
the manager will outperform the market after two years.
Assume you gave a young, undiscovered Peter Lynch—someone
who over the long run will outperform the market with a 5 percent perCHAPTER 20 Fund Performance, Indexing, and Beating the Market 347
TABLE 20–2
Probability of Outperforming the Wilshire 5000, Based on Returns, Risk, and Correlations from 1972
through December 2006