Put Your Favorite Guru To the Test

One common mistake investors make is assuming that, because their favorite advisor/guru/money manager has "made a lot of money," he or she is a stock-picking genius.  This assumption is great for money managers, as they collect fat fees on every dollar they manage.  It is not so great for investors, however, as they often pay too much for market-beating performance they don't actually get, or, worse, pay too much for past market-beating performance that wasn't really market-beating.

Assessing whether a manager has beaten the market is often more difficult than it seems, and any errors made in this process usually benefit the money manager.  To correctly assess whether a manager has beaten the market, you need to know:

• The appropriate benchmark against which to compare the manager's performance (all stocks, large-cap stocks, large-cap value or growth stocks, small-cap stocks, small-cap value or growth stocks, international, international small-cap, international value stocks, etc.) 

• The risk (standard deviation) of both the manager's portfolio and the benchmark.

Because different types of stocks have different risk/reward characteristics (and perform differently in a given period), electing the appropriate benchmark is critical.  If you choose the wrong benchmark, the manager may appear to be "beating the market" when he or she is actually lagging it.  Similarly, if the manager has taken more risk than the market (the benchmark), he or she has not really "beaten the market."  Higher risk usually equates to higher returns--but only in exchange for greater volatility.

An advisory firm called Index Funds Advisors has published a series of analyses comparing the performance of diversified portfolios of index funds with that of a few super-gurus: Warren Buffett, Ken Fisher, Bill Miller, Jim Cramer, etc.  The Buffett comparison is unfair, as the index-portfolio performance is compared against that of Berkshire Hathaway's stock instead of the performance of BH's book value.  The other comparisons appear fair, however. (See middle column, under "Benchmark Your Portfolio")

Check them out and watch the mystique of your favorite guru fade away...