When deciding which mutual funds to invest in, do you base your choices on past performance? If the answer is yes, you're in the majority. A vast number of investors choose to invest in last year's hottest funds in the hopes that the market beating returns will continue. However, as we have all heard before, past returns are not indicative of future returns.
Despite the fact that there is no correlation between past performance and future performance, investors continue to blindly accept the advertising thrust upon them through financial magazines and national television shows. While a certain number of professional money managers will manage to beat the market each year, these managers cannot be identified in advance. Moreover, the likelihood that they will repeat the performance the following year is extremely small.
One reason that market beating performance is hard to repeat is that once a fund has been promoted to death by its parent company, its assets tend to explode. In keeping with the fund's objective, the fund manager must now invest this money into the markets. With this increase in assets, he tends to push prices up before he can complete his purchases. The opposite also holds true, when attempting to sell a large portion of stock, his volume pushes the stock down temporarily before it returns to its normal price. Any advantage he may have had has now disappeared due to "asset bloat".
Another reason professional fund managers have difficulty maintaining market beating performance is that whichever sector propelled them to success in the first place is unlikely to continue outperforming. They must then guess which sector will continue its upward trend. Needless to say, the odds of correctly identifying the next hot sector are miniscule.
Many proponents of active management will point to how Peter Lynch has been able to beat the market for many years. However, up to 25% of his investments were in international markets, and not in US markets. It is futile to compare his returns to an S&P 500 fund when the investments are so different. The more accurate picture would be comparing his fund to international funds, many of which outperformed the S&P 500 at the time.
Finally, five-star ratings can be deceiving depending on the track record chosen. A mutual fund company may be able to deceive investors into believing a fund beat the market by simply changing the time horizon in which they are reporting.
The only method to achieving market returns is to build a portfolio of low-cost index funds and ETF's diversified through many asset classes around the world. Forget about past performance and instead focus on the correlation of one fund to another and proper asset allocation.
Karl Borris is the author of http://yourinvestingblueprint.wordpress.com/, an educational resource for those seeking better investment returns through Nobel Prize winning strategies. Join him as he explains how to use asset allocation, low-cost ETFs, and annual rebalancing to secure a sound retirement for yourself and your family.
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