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January 11, 2009

Past Performance Is Not an Indication of Future Results

You don't need to invest in a Ponzi scheme to lose all your money; most arbitrage strategies will get you sooner or later.

Let's say there's this absolutely fair and honest and even profitable investment. You, of course, do some diligence and find that the investment has returned .6% per month on the average every month for the past four years since it was founded – sometimes .55%, sometimes .65% - but variance you can live with. Moreover, you absolutely know (don't ask me how but you know) that it's not a Ponzi scheme.

You prudently invest a bit and, sure enough, for the next two years you get this nice return between .55% and .65% per month. The return isn't great but it beats the money you've been losing in the stock market. You're going to retire in five years and you figure that, if you put all your liquid assets into this and let them compound until you retire, you'll be able to live comfortably on the interest plus your pension and social security and even sleep at night. Why take any more risk?

What you don't know is that the investment strategy, which earns these consistent returns in good years and bad, has a half percent chance of losing all the fund's capital in any given month. Usually, of course, that doesn't happen. Statistically, it'll happen every seventeen years or so with an 50-50 chance that it'll happen in any eight year period although the occurrences are random. Bad luck, it happens just before you retire.

Were you defrauded? Only if someone said there was no chance of losing your capital. But probably the prospectus said that capital is at risk and past performance is not indicative of future results (right under where the past performance is displayed). If you do the math, you'll find that an investment with a 99.5% chance of returning .6% each month and a .5% chance of losing the principal (returning minus 100%) has a positive expected value - about .1% per month. That's the MEAN return but you've been looking at the MEDIAN return. We get fooled by the usual.

The investment described above is better than most hedge funds because it has a positive expected value – the real return on whatever the underlying investments are is greater than whatever management fees are being charged. In most cases hedge funds are like lotteries in that the expected return for all participants over time is less than zero because there are fees coming out of the pot. We usually loose when we play a lottery so, unless we have a gambling addiction, we don't get sucked in or tempted to bet our retirement on a single ticket. With many hedge funds we win most of the time (the usual return) but, when we lose, we lose most or all of our investment. The only hedge funds which are around to invest in are the ones which haven't yet lost all of their investors' money; they have positive track records or they'd be gone (as many are). Our brains are wired to think that past performance is THE indicator of future results no matter what it says in the prospectus.

In fact there are an infinity of arbitrage strategies which USUALLY have small positive returns; but, when they fail, they fail spectacularly. I think the promoters of funds based on these strategies even believe themselves that these are good investments. Maybe some are. But, unless there's an underlying investment in something that creates value, the expected return over time is less than zero after the fees come out. Since the returns are positive the vast majority of the time, the infrequent blowups are huge to keep the statistical books balanced.

Remember, this caution is about NON Ponzi schemes. It doesn't take a crook to part you from your money.

Nassim Nicholas Taleb explains these things much better than I do.

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