Be Wary of “Great” Mutual Funds

We humans are hard-wired to seek good and avoid bad—it’s one of our critical survival mechanisms. However, if you don’t compensate for your good/bad reflexes, it may be hazardous to your wealth.

When you cut through the analyses, and experts’ pontifications, most folks simply characterize “bad” stocks, mutual funds or markets as those that have been going down for a while. They sometimes even call them names: “dogs,” “pigs” or even “disasters” come to mind. Conversely, when prices have been rising, stocks and funds are “good.” If they’ve been going up for a long time, they are even “great!”

Naturally, investors buy good and great stocks/funds and do their best to avoid dogs, pigs and disasters. And there is never a shortage of experts to egging them on. However, if you are trying to construct a sensible investment program, you should be very wary of buying “great” stocks and mutual funds since they are most often identified by where they have been, not where they may be going.

In 1995 there were 18 funds in Morningstar’s Specialty-Technology category. Technology stocks soared in the years that followed and, due to popular demand, the number of tech funds grew five-fold to over 90. In 2000 they hit the wall and in the tech-wreck that followed, scores of “good/great” mutual funds, stuffed with “good/great” stocks, morphed into dogs, then pigs and finally, disasters—80% of their value vaporized in a little over two years. Then in the Fall of 2002 the technology sector began to rise and if you had the stomach to buy the dogs/pigs/disasters, you’d now be sitting on tidy 150% gains. However, disillusioned investors aren’t convinced tech is great, or even good—they have been selling all the way up. Tech funds contain hold smaller assets now than they held at the 2002 bottom.

The transformation of great to ghastly investments isn’t confined to Wall Street. On Main Street, not long ago, residential real estate was great. Now, depending on where you live, experts quoted in the Wall Street Journal say it’s somewhere between dog and disaster.

People think in a linear fashion; that is, we tend to believe that what has been good is likely to stay good; badness is just as likely to persist. Consumer’s Reports’ successful franchise is built on this assumption. Most of the time, our assumptions serve us well. However, Wall is not a one-way street—it is cyclical—and if you project obviously good or bad trends in a straight line to the horizon and beyond, you will find yourself yinging when you should be yanging: buying near cyclical tops and selling near bottoms.  Bernard Baruch was asked what the market was going to do and he famously said, “It will fluctuate.” He wasn’t kidding.

Human nature and cyclicality can play hell with investors’ returns. Consider the fact that the average mutual fund investor receives lower returns than the very funds he or she invests in. Huh? How does he manage that? By buying more around market peaks and selling more near market bottoms. Mistiming is particularly rampant in volatile sectors.

Late last year fund-tracker Morningstar calculated returns for the technology sector mentioned above. The category’s average annual return for the most recent 10-year period at that time was 6.4%, even after the 2000-2002 meltdown. However, “investors… in aggregate had a terrible experience in those funds, losing an average of 4.2% on an annualized basis…”(emphasis added). Studies of other less volatile sectors turned up disparities that were less dramatic, but still showed investor returns trailing fund returns significantly, due to self-inflicted mistiming.

Many people harbor a visceral distrust of Wall Street and its practitioners and rightfully so. The trading and mutual fund scandals of a few years ago confirmed their darkest suspicions.

However, mutual fund investors’ losses in scandal-plagued funds were insignificant compared to the shellacking performance-chasing investors inflicted upon themselves.

The lessons? One is that while you can’t predict or control the economy, interest rates or the stock market, there is one thing under your complete control: your own behavior. Another: While you might think of yourself as an average Joe or June, you simply can’t afford to make the mistakes made by the average investor.

Is investing hopelessly complicated? No—unless you want it to be. It does take discipline and some attention, and I suppose if you’re new to the game, somewhat of a leap of faith. But after all, nobody cares—or should care—more about your money than you.

If you invest on your own, you’ll improve your results by monitoring your good/bad reactions to market volatility and making more decisions with your brain instead of your stomach. If you don’t like—or have no interest in the investment process—put your portfolio on autopilot using index funds; your returns will be better than the average investor’s by asignificant margin. Or, you can hire professionals to invest for you. Make sure they are earning their keep—keep score.

November 16, 2007

—Jerry Tweddell