
Here's a question:
“I’m now eligible for my 401(k), and I need to pick which mutual funds to invest my contributions into. I’m not sure exactly how to do this, but I can see which ones had the best returns over the last one, three, and five years, so I just thought I’d put all my money into the top two or three of them so I’m diversified. Is that the right approach?”
Performance chasing is widely recognized by behavioral economists as a serious investing error. In fact, it’s such a bad idea that mutual funds are required by law to include a statement in their paperwork saying something to the effect that past performance is no guarantee of future results. I wish the statement were even stronger, saying something like, “Outsized past performance is highly likely to reverse in the near future.” But, alas, investing is a caveat emptor activity.
Performance chasing is easy to do. It is often driven by FOMO—the fear of missing out. We hear about our friends making money in ARK funds, meme stocks, Beanie Babies, or Bitcoin, and we pile in, only to suffer through the inevitable downturn inherent in popular investment booms. At that point, fear of loss usually kicks in, and we sell low. “Buy high and sell low” is not a recipe for investment success.
The truth is that the outperformance of a few mutual funds in your 401(k) is far more likely due to what they invest in than the skill of their managers. For example, over the last 5-10 years, US stocks have generally outperformed international stocks, bonds, and real estate—especially the large cap growth and tech stocks, like NVIDIA, Meta (Facebook), Amazon, and Alphabet (Google). Any mutual fund that was invested heavily in those stocks will demonstrate excellent results over the last few years, no matter their investment strategy. Chances are, the top two or three funds in your 401(k) are all invested in those same types of stocks, and buying three funds that all invest in the same stocks is just false diversification.
The data are very clear that the outperformance of active mutual fund managers does not persist. Well, it may but only among the worst ones. Some studies show that the top quintile of managers for a given year are no more likely to be in the top quintile the next year than any other manager, but the bottom quintile managers are actually more likely to be in the bottom quintile the next year. Sometimes, their funds simply close and disappear from the historical record. A more recent study by the mutual fund gurus at Morningstar concluded:
“Over the long term, there is no meaningful relationship between past and future fund performance. In most cases, the odds of picking a future long-term winner from the best-performing quintile in each category aren’t materially different than selecting from the bottom quintile. The results strongly indicate that long-term investors should not select funds based on past performance alone.”
As a rule, the more you pay for an investment, the worse its future returns will be. If you can buy a rental property with a net income of $20,000 for $200,000, that will probably be a great investment. Not so much if you pay $600,000 for that same property. That’s exactly what happens when you buy any other investment after a recent runup in price. You’re paying more for every dollar of earnings it generates, and thus your return must be lower than that of an investor who bought it at a lower price.
Any student of the markets will quickly see that there is a pendulum effect as different types of investments come in and out of favor. Sometimes, growth stocks do well. Sometimes, value stocks do well. Sometimes, small stocks or Chinese stocks or utility stocks do well. Sometimes bonds or real estate perform well.Predicting which will do best in the near future is extraordinarily difficult. It’s so difficult that it is probably not worth trying to do. Certainly, there is no evidence that just buying whatever did best in the last year, three years, or even five years is going to lead to investment success. But doing the opposite isn’t any more successful; you can’t just take a contrarian approach and buy whatever did most poorly last year, either. Sometimes, stocks have gone down in value for a reason—because the company is en route to bankruptcy. Perhaps if it recovers, you will make out like a bandit by buying low. The company behind the stock often does not rebound; good or bad performance may persist longer than expected.
What should an investor do if they can’t just pick the best-performing funds out of their 401(k)? How about creating a reasonable, written investment plan instead? Determine a priori how much of the portfolio will be invested into US stocks, international stocks, bonds, real estate, and other investments. Then look “under the hood” at what the available funds in your 401(k) actually invest in and choose them based on the underlying investments. Among funds that invest in similar investments, the best predictor of future performance is low costs, so choose the one with the lowest expenses. These will usually be index funds.
If you need help doing so, consider hiring a fiduciary, fee-only financial planner who provides good advice at a fair price. While this stuff is not that hard to learn, the consequences of doing it poorly (or not doing it at all) compound over time. It may be well worth paying a few thousand dollars to get started on the right foot.
Whatever you do, don’t just buy the hottest-performing stock, mutual fund, or other investment available—that approach does not necessarily lead to long-term investing success.
Have you chased performance in the past? How did it work out for you?
[EDITOR'S NOTE: This article was originally published at ACEPNow.]
Although the concept was alluded to, I’m surprised that ‘mean reversion’ was not mentioned anywhere in the article.
That one phrase is all that is necessary to explain why not to invest in past winners.
The only issue with mean reversion is that there is no guarantee it will actually occur with every investment. The more diversified the investment, the more likely you are to see it of course. Like you expect to see it with international vs US stock index funds or growth vs value index funds but there is no guarantee that if your Bitcoin or NVIDIA goes down that it will somehow come back up later.
Long ago before I understood the concepts of long term and short term investing I got my best friend and my not yet husband to invest in Vanguard stock mutual funds as I was doing. Both of them sold these investments in the next few years- my husband one year later. My BF lost money and complained about my advice- so I learned not to give her financial advice although it has been painful over the decades as she tells me what her finance guy has advised her to do this year (and I think about how his salary is well funded by the difference between her investment yields and mine).
My (then still future) spouse’s shares had doubled in value at the time he decided he wanted to buy a new car and used that money for that purpose. For several years afterwards when I discussed investing with him he would urge me to invest our money in that thing that paid 100% per year. Hopefully he was only joking the last few times.
And now my youngest has a salary and a chunk we’ve passed on from Oma. I hesitate to urge her to lump sum it into the stock market given stocks’ outsized performance lately and my experience with her dad and my BF. Compromise: her tax deferred accounts stocks largely, her taxable accounts MM given looming house purchase next decade and her lack of interest in stocks and money management anyway. Hoping she’ll catch the bug- this kid used to say she wanted her uncle’s job- unemployed er independently wealthy managing his portfolio (workable income given he has no kids and his partner works for her share of expenses).
Just curious if you tried to teach your daughter your financial wisdom and how it was received by her?
I’ve always thought of active investing like this:
Individual Stock Investment: You pick stocks. There are roughly 2272 stocks listed on the NYSE and 3450 on the NASDAQ. It is very difficult, if not impossible, to consistently pick which of those will be winners.
Actively Managed Mutual Fund Investment: You pick a manager who picks stocks for you. There were 6431 actively managed mutual funds in 2023. Will you be any better at choosing a manager than you were at stocks?
Investing Through an Advisor: You pick an advisor who picks the mutual fund manager who picks the stocks. The Bureau of Labor Statistics showed 321,000 financial advisors in the U.S. in 2023. Will you choose the right advisor who chooses the right manager who chooses the right stocks?
The odds are not in your favor with active investing. It’s probably better to use passively managed broad-based mutual funds, index funds, or ETFs.
“Outsized past performance is highly likely to reverse in the near future”….Bitcoin enters the chat. Been hearing Bitcoin will crash and its too high for years now and just keeps going up. Getting so sick of sitting on the sidelines thinking it will crash soon and everyone else around me gets rich making 5,000% returns. But I know as soon as I put money in it will drop.
“As a rule, the more you pay for an investment, the worse its future returns will be. If you can buy a rental property with a net income of $20,000 for $200,000, that will probably be a great investment. Not so much if you pay $600,000 for that same property. ” So even if index funds have had huge runs up you still just keep plowing money in them no matter what?
I liked the movie Bagger Vance too.
I don’t know what future Bitcoin returns will be nor what future stock market returns will be. I really don’t. I don’t buy Bitcoin primarily because its return is entirely speculative. My financial plan indicates I’ll put 60% of my money into stocks and it’s worked very well for the last 20 years so I intend to keep doing that.
As a general rule I’ve found beginning investors have trouble staying the course at market lows and intermediate investors have trouble staying the course at market highs. Advanced investors just stay the course. They know that sometimes their investment into a diversified stock portfolio will have great returns and sometimes it will have mediocre returns and sometimes it will have poor returns over the next 5 years. But over the next 50 years it’ll work out even those few times you buy “after huge run ups” that rapidly reverse.