What is the next big investment opportunity?

What is the next big investment opportunity, and can you really identify it in advance?

It's a tempting question, but the honest answer challenges how most people invest. According to research from the University of Mannheim in Germany, investors consistently overestimate the importance of skill and underestimate the role of chance in investment returns, and that mistake leads many of us to chase opportunities that were never really there.

In this video, Professor Martin Weber explains the findings of the study, tellingly titled "Fooled by Randomness: Investor Perception of Fund Manager Skill." The researchers found that most investors choose an actively managed fund based on its past performance, without appreciating how much volatility skews those returns. They assume a manager who performed well must be skilful, when in reality that manager often outperformed simply by taking on more risk. Weber's first and clearest piece of advice is blunt: don't look at past returns, and don't chase them, because most of the time what you're really picking up is randomness.

You'll learn why genuinely skilled fund managers, though they do exist in very small numbers, are so hard to rely on. Some argue you'd need to observe a manager for 100 years to be sure their record reflects skill rather than luck. And even if you could identify a truly skilful manager, there's a second problem: are they worth the cost? A skilful manager who is cheap might be worth backing, but in practice, skilful managers tend to be expensive, which erodes much of the advantage.

The video also explores why so many of us keep trying to spot the next Warren Buffett despite the odds. Professor Weber puts it down to two forces: industry advertising and the media. Passive investing is, frankly, boring, so the media has every incentive to write about active funds instead. And from the industry's point of view, active funds are far more profitable than cheap passive ones, so there's little motivation to promote the lower-cost option.

The takeaway: the next time you're tempted to buy a fund on the strength of an advert or a glowing newspaper article, be cautious. It might just turn out to be a consistent star performer, but the odds are heavily stacked against it. Far better to recognise the powerful role of chance, resist the lure of past performance, and keep your focus on a low-cost, evidence-based approach.

Chapters / Key points

• Why investors overestimate skill and underestimate chance
• The University of Mannheim study: "Fooled by Randomness"
• Why chasing past performance usually means chasing randomness
• How volatility skews fund returns
• Why skilful managers are so hard to identify
• Why even skilful managers may not be worth the cost
• Why we still try to spot the next Warren Buffett
• How advertising and the media favour active funds
• Why you should be wary of buying funds on adverts or articles

Transcript

What is the next big investment opportunity?

Robin Powell: Hello there. Investors overestimate the importance of skill and underestimate the role of chance in investment returns. That's the key finding of a study conducted by researchers at the University of Mannheim in Germany.

The study's entitled "Fooled by Randomness: Investor Perception of Fund Manager Skill." The researchers found that most investors base their decision on which actively managed fund to invest in on past performance. However, they fail to appreciate the extent to which volatility skews returns. They assume that managers who've performed well were skilful, when in fact they outperformed simply because they took on more risk. Here's Professor Martin Weber.

Professor Martin Weber: If you take the results together and ask yourself, "What should I do?", the first thing is: don't look at past returns. And you don't chase past returns. Period. Most of the time, if you chase past returns, what you pick up is randomness.

Robin Powell: Professor Weber accepts there are a very small number of skilful fund managers out there. But, he says, that's not the point.

Professor Martin Weber: The next question would be, "Can you find these people? And is it worth it?" And the answer is, it's very hard. Some people say you have to wait for 100 years in order to find out who's a skilful manager. Suppose you find a skilful manager: is he or she worth the money? If you have a skilful manager who is cheap, then go for it. But in general, skilful managers are expensive.

Robin Powell: So, given how unlikely it is that you or I can identify the next Warren Buffett, why do so many of us try to do just that? For Professor Weber, it's mainly down to two things: industry advertising and the media.

Professor Martin Weber: You have to admit that passive investing is boring. The media has every incentive to write about active. So the news is against us in investing. From the industry's point of view, passive is much cheaper than active, so why should I promote it when I can earn more money on the active side?

Robin Powell: So, next time you're tempted to buy a particular fund on the strength of an advert or an article in a newspaper, beware. Yes, it might just become a consistent star performer, but the odds are heavily stacked against it. Until next time, goodbye.