Threshold Distortion

I coined the term Threshold Distortion. It describes a common analysis error.

The threshold refers to how mutual funds are selected. They are the best 20 or 30 over a recent time interval. The distortion is when the mutual funds are bought. They are bought immediately. They are bought at their highs.

By virtue of this process, the selected funds have all random factors working on their behalf when bought. Later on, the random factors return to normal, ending up close to zero. If skill were absent, we would expect subsequent returns to fall far behind the rest of the market. Buying the funds at their highs creates a strong, downward bias in subsequent returns.

Skilled investors wait for a good price.

Have fun.

John Walter Russell
December 2, 2007