By 
Buy high and sell low – not a typo.
Millions of investors guarantee their failure by selecting stocks and mutual funds based on quarterly or annual performance records. Do you chase performance? You may be buying high and selling low!
As the year draws to a close, millions of mutual fund investors begin an annual event to guess the winners for the coming year. However, most of these people rely heavily on a time-honoured, but terribly wrong, method of assessing strength. Whether analyzing website screening tools, reviewing fund honor rolls in magazines, or using star ratings from fund analysts, savvy entrepreneurs often foolishly chase last year’s top investment returns.
This raises 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 from 1994 to 2003 were analyzed. Here are the results:
— Only 16% of the top five funds make 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 within the next 10 years.
Academic studies and market statistics confirm that the typical investor acts in direct opposition to the sage advice: buy low, sell high. It is only after high returns are reported that investors invest money in stock and bond mutual funds. In fact, Financial Research Corporation compared investor cash flows to mutual funds. The purchases immediately following the best-performing quarters are 14 times greater than those immediately following the worst-performing quarters. In other words, you are 14 times more likely to buy funds at the higher price than at the lower price. 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 Analysis of Investor Behavior. The study confirms bad timing for investors and the resulting financial carnage. Investors buy funds immediately after a rapid price appreciation. This happens just before the return on investment declines. Prices fall soon after, and investors quickly dump their holdings to search for the next attractive fund. The resulting returns don’t even beat inflation! When measured over the past nineteen years, the average equity investor earned a meager 2.6% annual return. Compare that to a 3.1% inflation rate and a 12.2% return for the S&P 500 over the exact same time period. Investors were not only unable to keep up with the market, but also lost money due to inflation.
We’ve all seen the warnings on cigarette packs. Even smokers understand its importance; Smoking is not a healthy activity. So why don’t investors heed warnings about mutual fund returns? All of you have also seen those statements. But can 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 happens 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 focus 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) Seniority: How long have the managers and advisors been with the fund?
(3) Management: Well-known, highly respected managers (eg, remember Peter Lynch)?
(4) Consistency: Are all 3-, 5-, and 10-year returns above average?
Finally, measure returns based on your entire portfolio. History shows that the success of a single investment is not repeated. Accept the fact that each year is different and brings new leaders and laggards. Use an asset allocation strategy to ensure balance and increase long-term returns on all your investments. Invest in a diversified portfolio to meet your financial goals and stick with it.
Still haven’t learned your lesson? Consider this: Fourteen mutual funds topped the 2003 charts with returns greater than 100%. In 2004, these fourteen funds lost more than 4% while the S&P 500 gained 3%. Congratulations, chasing performance you lost 7% of your money this year.