Why invest in a "risky" fund?

[n_bear]

I'm struggling to understand the value of picking one mutual fund over another.  If I'm only concerned about long term gains, aren't all funds essentially the same?

Take, for example, an S&P index and a small cap growth index.  If the small cap growth stocks are consistently producing higher returns than the S&P index, wouldn't the market respond and buy those stocks to the point that they wouldn't be more profitable than the stocks in the s&p?  I understand that the small cap growth index is more volatile, but why does it have a better expected value?

In general, I'm asking why any fund ever consistently outperforms another fund.  The market has so much depth that I would imagine the expected value of all funds would be equal when looking at a large time horizon.

Thanks in advance.

[warfreak2]

I understand that the small cap growth index is more volatile, but why does it have a better expected value?

Think of it as a risk premium; you're being paid (on average) more for putting your money at a higher risk.

The maths/economics explanation is that dollars aren't all worth the same; an extra dollar is worth more to you if you only have a thousand of them, than it's worth if you already have a million of them. (This is measured by a utility function). The dollars you might potentially gain are therefore worth a little less than the dollars your might potentially lose. The bigger those swings, the more effect this has, so to make it a sensible gamble, you have to potentially gain more dollars compared to the dollars you might lose.

The market has so much depth that I would imagine the expected value of all funds would be equal when looking at a large time horizon.

Not everyone invests for the long-term, and the long-term means different things to different people.

[wtjbatman]

Take, for example, an S&P index and a small cap growth index.  If the small cap growth stocks are consistently producing higher returns than the S&P index, wouldn't the market respond and buy those stocks to the point that they wouldn't be more profitable than the stocks in the s&p?  I understand that the small cap growth index is more volatile, but why does it have a better expected value?

Small cap growth has higher returns than an S&P500 index because small companies have more room to grow and can grow faster than large companies. On the other hand, small companies are more likely to go out of business, and have a smaller moat protecting their company/product/wealth, especially during a recession.

I think of a poster on Bogleheads recently who invests in small cap stocks, and lost $400k of a 500k investment because the stock dropped by 4 points, from $5 a share to $1 a share. If he had invested in Coca-Cola (KO), he wouldn't have experienced the same initial growth, but KO is also never going to lose 80% of its market value in one day.

The return has the potential to be greater, but it is also riskier, especially in the short term. And as warfreak2 pointed out, every investor is different. Someone who is expected to live another 60 years likely has a different mindset and is more risk tolerant than someone who is 80 years old and wants the safest return (notice I didn't say greatest return) on his dollar as possible.

[hodedofome]

Strategies come and go. Sometimes value investing is knocking it out of the park while growth or momentum is lagging, or vice versa. You are correct that a strategy won't outperform every year. Eventually there is performance chasing and the strategy will mean revert.

Look at managed futures funds in 2008. Some of them were up 20, 50, 70%+ while the rest of the market was down by 30%+. It was a banner year for these funds, better than they've had since probably the early '90s. A ton of money piled into these funds and they've sucked ever since.

A lot of value investors had a fantastic year last year. It is most likely that they will underperform for some time in the future.

The pros understand that the strategies that have historically outperformed over a long time, but have sucked the past 3-5 years, are the ones to look at. The problem is that the individual investors are always chasing performance. They chase the funds that have done the best, when they should really be looking at the ones that have done the worst. Obviously, you need to weed out the funds that suck because their fees are high or their strategy is poor.

All that said, most individual investors will do best with index funds and something like a 50/50 or 60/40 portfolio, diversified throughout the world and not just a US-focused allocation.