A friend sent me some monthly and yearly performance data on a fund he was looking at.  He asked if I could make a quick guess on its annualized return.  Embedded in this simple puzzle are several important lessons.  But before we talk about those implications, take a stab at what the overall (annualized) performance of this investment was.  Please, no cheating with Excel; let your emotions rule not your logic:


After staring at this for a minute or two, I concluded that it would be in the black, perhaps significantly. But the answer is not at all what I expected; the overall performance of the fund would have been down 6.6%! I was surprised, to say the least.  I asked a friend of mine with a PhD in physics to try the quiz, and he failed, just as I had.  So I felt a bit less foolish.

But, what is going on here?  At first glance, one would think that the fund’s disastrous performance in 2008 – down 74.02% – should have been wiped clean by 2009’s extraordinary return (up 76.11%). Moreover, the fund continued its march northward for the next three years. But math is math: the fund’s precipitous decline in 2008 – so early in the game – made it nearly impossible it to recover.

This is certainly – at least for me and my physicist friend – non-intuitive and surprising.  But there are interesting insights to be garnered from this experiment:

First, compounding of returns is a huge driver of long-term investment returns.  Avoiding major investment mistakes (through over-concentration in a few stocks or the absence of an asset allocation plan) can make the difference between a very comfortable retirement and no retirement at all.

Second, math is often not intuitive.  It is crucial to make investment decisions based on hard analysis and math; not emotions.

Third, don’t be fooled by simple three, five and ten year averages for investment returns.  Understand the volatility of the investments that you make.  It is impossible to choose the “right” years to invest, so high volatility increases the odds that you will have a significant down year (potentially early in the life of the investment). That will result in investment performance that is substantially worse than the advertised averages.

Let’s explore that last point a little further with a well-known real-life example from one of the best mutual fund managers of our generation.

Consider the record of Legg Mason’s legendary manager, Bill Miller. Mr. Miller — knighted by the financial press — beat the S&P 15 years running.  From 1990 to 2005, he out-performed the S&P by 3.3%:

1990-2005 annualized performance

Value Trust …… +13.8%

S&P………………… +10.5%


So, how did the hordes of investors who jumped on the Miller bandwagon fare when they finally bought in January 2006?  They underperformed the S&P index by over 8%:

2006-2012 annualized performance

Value Trust …… -4.2%

S&P………………… +4.1%


It ends up that Mr. Miller suffered a similar fate as the fund from our pop quiz. Here are his annual returns:


Mr. Miller’s disastrous performance in 2008 would have made catching up to his S&P benchmark very difficult. However, even though he recovered nearly miraculously in 2009 (when he beat the S&P as he had done so many years in the past), his luck (or skilled run) had ended. He resigned from the helm of the Value Trust in November, 2011 after nearly 30 years of service.

We can learn several additional lessons from this analysis. First, chasing performance is fraught with peril. There are very good reasons the SEC requires investment managers to say that “Past performance is no guarantee of future returns.”  Second, extraordinary performance necessarily entails taking on excessive risk.  One really bad period can ruin long-term performance.