Buy high and sell low – not a typo.
Millions of investors guarantee failure by selecting mutual funds and stocks based on quarterly or annual performance records. Are you chasing performance? You may be buying high and selling low!
As the year draws to a close, millions of mutual fund investors start an annual event to guess next year’s winners. However, most of these people rely heavily on a traditional, but terribly wrong, method of assessing strength. Whether it’s analyzing website screening tools, reviewing fund honor lists in magazines, or using fund analyst star ratings, normally savvy entrepreneurs foolishly chase the returns on the hottest investments of the past year.
This begs the question: Can high-yield mutual funds lead two years in a row? Consider a study commissioned by Vanguard Investments Australia and published by Morningstar. The five best performing funds were analyzed between 1994 and 2003. Here are the results:
– Only 16% of the top five funds make it to the following year’s list.
– The top five funds average 15% lower returns the following year.
– The top five funds barely outperformed (by 0.3%) the market the following year.
– 21% of the top five funds ceased to exist in the following 10 years.
Academic studies and market statistics confirm that typical investors act in direct opposition to wise advice: buy low, sell high. It is only after high returns are earned and reported that investors invest money in stock and bond mutual funds. In fact, Financial Research Corporation compared investors’ cash flows to mutual funds. Purchases immediately after the best-performing quarters are 14 times greater than purchases immediately after the worst-performing quarters. In other words, you are 14 times more likely to buy funds at the highest price than at the lowest. Buy high and sell low.
What kind of damage are they inflicting on your investment returns? DALBAR, Inc., conducted a well-known study called Quantitative Investor Behavior Analysis. The study confirms the poor timing of investors and the resulting financial carnage. Investors buy funds immediately after a rapid price appreciation. This happens just before the return on investment diminishes. Prices drop shortly thereafter and investors quickly ditch their holdings to find the next hot bottom. The resulting returns don’t even beat inflation! When measured over the past nineteen years, the average equity investor made a meager annual return of 2.6%. Compare that to a 3.1% inflation rate and a 12.2% return on the S&P 500 over the same time period. Investors not only failed to keep up with the market, they also lost money due to inflation.
We have all seen the warnings on cigarette packages. Even smokers understand its relevance; smoking is not a healthy activity. So why aren’t investors heeding warnings about mutual fund returns? You have all seen those statements too. But do you remember what is said? Past performance is not a guarantee or indicator of future results. Research and studies have proven this fact, but most investors choose to ignore this warning. Yes, it is an easy way to compare funds. It also turns out to be completely irrelevant. Let me evangelize these words for you. Past performance does not predict future results!
Here’s how you can stop chasing short-term performance and stay focused on your financial goals. Identify appropriate long-term investments by evaluating the following:
(1) Leadership: How does the fund perform relative to funds of similar size and style?
(2) Tenure: How long have the managers and advisers been in the fund?
(3) Management: Well-known and respected managers (for example, remember Peter Lynch)?
(4) Consistency: Are the 3-, 5-, and 10-year returns above average?
Lastly, measure returns based on your entire portfolio. History shows that no investment success is repeated. Accept the fact that each year is different and brings in new leaders and laggards. Use an asset allocation strategy to ensure balance and increase the long-term profitability of all your investments. Invest in a diversified portfolio to meet your financial goals and stick with it.
Haven’t you learned your lesson yet? Consider this: Fourteen mutual funds topped the charts for 2003 with returns above 100%. In 2004, these fourteen funds lost more than 4%, while the S&P 500 gained 3%. Congratulations, chasing performance lost 7% of your money this year.