Risk-free outperformance isn't possible. A manager with an expected annual outperformance of 3 percent has a four-in-five chance of lagging the benchmark by 10 percent or more at least once in a five-year period, according to Newfound Research's analysis. Shifting in and out of that manager's fund just because he underperforms would be costly. As hedge fund manager Greenblatt notes, there isn't a correlation between a manager's three-, five- and 10-year records in the past and how they will do in the future. What's more important is understanding the strategy and having the confidence to follow it long-term.
But truth be told, many investors, including professionals, can find it difficult to grasp the facets of an investment strategy and tend to overweight recent returns. (For the record, Berkshire Hathaway is up 25 percent this year — 15 percent since November — with the Trump election boom in bank stocks a big part of that move up.)
Even if investors do understand what goes into the investment approach, it can be hard to distinguish between luck and skill. This is why indexing can be a good option for many investors, assuming they can stick with an index through the market's good and bad times. However, for those investors who seek outperformance over the market and are willing to tolerate relative underperformance over periods of time, the key ingredient to success is staying committed to an active strategy or manager when it underperforms.
In the end, investors should understand and accept how much risk they are willing to take and build a portfolio that tries to match it and stick to it for the long-term. An investor who understands there is a certain element of risk to investing is more likely not to panic when markets go awry.
— By John Reese, co-founder at Validea Capital Management, which manages the Validea Market Legends ETF (VALX)