Mutual Fund Performance

What is the most common mistake made by mutual fund investors? The answer might surprise you.

Most investors select mutual funds based on past performance. This seems perfectly logical. You would think that a mutual fund manager with a good track record must be doing something right. If she has outperformed the S&P 500 over the past five years, isn't she likely to continue to perform well in the future? The fund companies do all they can to encourage this kind of thinking because it helps them attract new investors. Most of the ads for mutual funds show stellar returns over the past few years. The implicit assumption is that you can expect similar results going forward.

The only problem with this approach is that past performance has almost no predictive value for future returns. A recent study published in the highly regarded Journal of Finance evaluated the performance of mutual funds touted in Money Magazine and Barron's. The advertised funds had superior performance in the one-year period preceding the ads. However, the funds underperformed their relevant peer groups after the ads appeared in press. On the whole, investors who purchased the advertised funds would have been better off picking un-advertised mutual funds at random.

This is not the first scientific study to debunk the notion that you can pick a winning mutual fund based on its track record. In fact, this has been demonstrated again and again in the academic finance literature. That's why, if you look closely at a mutual fund ad, you'll find a disclaimer in small print that states "past performance cannot predict future results."

So how should you pick a mutual fund? I suggest you begin by developing a sound asset allocation strategy based on your investment goals and constraints, and pay careful attention to expense ratios and tax efficiency.

August 1, 2000

Back to learning Center

Recommended Reading for Investors