Every single day, I get asked these questions: What mutual funds should I invest in? What is best? What do you like today? What do you think of this, that or the other fund? Where do you see the best opportunities? If you are ‘normal’, you will be thinking these same thoughts.
Here’s the unfortunate reality of the whole thing. There is no such thing as the best investment and even if there is such a thing, no one has the ability to predict what it will be ahead of time.
In the next few weeks, I will walk you through some of the research we went through to writing my book Mutual Fundaments. I will discuss some of the dos and don’ts of selecting mutual funds. In this article, I want to start by looking at the three biggest mistakes investors make:
This is by far the biggest mistake investors make. According to our research, there is over an 80% correlation that last year’s best performing investments will be the most popular investments. Think back to the Emerging Markets in 1993, Financial Services in the mid 1990s and Technology in the late 1990’s. Today investors are flocking to fixed income. If chasing performance is your key strategy to selecting investments consider these facts:
- Everything goes in cycles (interest rates, stock markets, sectors, mutual funds, economies, businesses, etc). What goes up can come down. Just because it was the best, does not mean it will stay the best.
- If it were that easy, we would all do it and chasing performance would always work. Well, we all do it but unfortunately, it rarely works.
- Short-term performance is a random walk. It cannot be predicted.
- Chasing performance does not work. According to our research, you have less than a 10% chance that this years top performing investments will be next years top performing investments. In other words, you have a 90% chance of being wrong.
Knowing which sector, market or investment will be the best is impossible. It is just like predicting the future is impossible. Understanding the past is easy. It’s like understanding the technology sector. In hindsight it is easy to understand what happened and why. But back in 1999, how many people predicted what was going to happen with any degree of accuracy. To take this a step further, if you were one of the few who did get it right, what is the probability that you will get it right again? And again? And again? Just to emphasize my point, what will be the best investment for the next 12 months?Investing is a science. It requires structure, discipline, and process. It is not about Ouiji boards, the position of the stars, feelings, intuition or guessing what will be the next best thing (for a while).
Single dimensional analysis.
What are you looking for in a mutual fund? Chances are it has something to do with performance. Performance drives investments decisions and why not? We invest money to make money so performance becomes the key determinant of selecting mutual funds.Consider that performance is only one dimension of a mutual fund. While it is one of the most important determinants, it is not the only determinant. Choosing a mutual fund based on performance and performance alone is what we call single dimensional analysis – you are looking at only one aspect or dimension. In other terms, it is no different than buying a car based on color and color alone. Would you buy a car just because it is red? You would not take into consideration, the brand, age of the car, condition of the car, options, etc.
Far too often, investors look at performance (1, 3, 5 and 10 year returns) without looking at very important characteristics like investment discipline, management fees, taxation, holdings, and risk just to name a few.Proper investment analysis requires good research. Good research comes from multi-dimensional analysis.