How about a Saturday reminder, via Blodget at Slate, not to invest in a mutual fund based on its past performance?
Most investors have heard the "past performance" warnings before, but like other common mantras, do not heed them. Why not? Because they defy common sense. Above-average fund managers should have beaten the market, while below-average ones should have lagged it. So, all we need to do, the logic goes, is to look at some past performance—and pick a few managers who have put the market to shame.
The first of many reasons why this logic is flawed is that excellent past performance is often the result of something other than skill—namely, chance. In any given period, a random selection of stocks will beat the market about half the time. Similarly, a random selection of fund managers will beat the market about half the time (before costs). As a result, the difference between a supertalented fund manager and an average one is often as hard to discern as the difference between a .350 hitter and a .280 hitter in baseball. Over many seasons, with the help of detailed statistics, the difference is obvious. Over a few dozen at-bats, however, the hitters often look about the same.
Second, strong past performance is often the result of the temporary dominance of a particular investment style: growth stocks in the late 1990s, for example, or value stocks and small stocks from 2000 to 2006, etc. When a particular fund manager's style is in vogue, the fund can post extraordinary returns. These returns can disappear quickly when the market environment changes, however. (If you could predict the future, you could theoretically switch from style to style, but the whole problem with stock-picking, market-timing, etc., is that most people aren't Nostradamus.)
Third, even if you do manage to find a fund whose excellent past performance is the result of skill, something critical to the performance might soon change—leaving you with a frightfully ordinary fund (and facing a big transaction and tax hit if you decide to ditch it)."
Why do we post so many articles warning against the dangers of relying on past performance to make mutual fund investing decisions? Because, believe it or not, past performance is still the number one factor mutual fund investors consider when making buying decisions.
How about a Saturday reminder, via Blodget at Slate, not to invest in a mutual fund based on its past performance?
Most investors have heard the "past performance" warnings before, but like other common mantras, do not heed them. Why not? Because they defy common sense. Above-average fund managers should have beaten the market, while below-average ones should have lagged it. So, all we need to do, the logic goes, is to look at some past performance—and pick a few managers who have put the market to shame.
The first of many reasons why this logic is flawed is that excellent past performance is often the result of something other than skill—namely, chance. In any given period, a random selection of stocks will beat the market about half the time. Similarly, a random selection of fund managers will beat the market about half the time (before costs). As a result, the difference between a supertalented fund manager and an average one is often as hard to discern as the difference between a .350 hitter and a .280 hitter in baseball. Over many seasons, with the help of detailed statistics, the difference is obvious. Over a few dozen at-bats, however, the hitters often look about the same.
Second, strong past performance is often the result of the temporary dominance of a particular investment style: growth stocks in the late 1990s, for example, or value stocks and small stocks from 2000 to 2006, etc. When a particular fund manager's style is in vogue, the fund can post extraordinary returns. These returns can disappear quickly when the market environment changes, however. (If you could predict the future, you could theoretically switch from style to style, but the whole problem with stock-picking, market-timing, etc., is that most people aren't Nostradamus.)
Third, even if you do manage to find a fund whose excellent past performance is the result of skill, something critical to the performance might soon change—leaving you with a frightfully ordinary fund (and facing a big transaction and tax hit if you decide to ditch it)."
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Why do we post so many articles warning against the dangers of relying on past performance to make mutual fund investing decisions? Because, believe it or not, past performance is still the number one factor mutual fund investors consider when making buying decisions.