“If past history was all there was to the game, the richest people would be librarians.” – Warren Buffett
A few weeks ago, I had a phone call from a woman who wanted to change the investments that she had in her Group RRSP. She’d just received her statement and was disappointed with the return. When she looked at the returns of other funds in her plan she saw that there were lots of funds that had done better than hers and so she decided that she wanted to make a change towards chasing winners. Knowing that the default fund in her group plan was a low interest money market fund I wondered if that might be the reason for her low returns but when I pulled up her profile to take a look at her investments, I saw a mix of fixed income and bond funds. That mix was drastically different from the funds she was thinking of switching to and, after asking a few questions, it became very apparent that the high performing funds she had chosen didn't match her (very low) risk tolerance. Her ‘ chasing winners ‘ approach to selecting investments isn’t uncommon but, as an investment strategy, it rarely works out as positively as people might hope. Here are some reasons why:
Compare Apples with Apples
The composition of a mutual fund varies greatly from fund to fund. Each fund has a goal and that goal determines what the fund's assets are invested in and what percentage of the fund is invested in equities.
Related article: Understanding Asset Allocation
Generally speaking, the greater the percentage of equities, the greater the potential return and the greater the potential risk. Comparing the returns of funds with very different goals is like comparing a racehorse to a donkey; it’s not a fair comparison because the two animals are used for such different purposes. In a race across open fields the racehorse is obviously going to be the stronger performer but when it comes to carrying a heavy load along a mountain trail the donkey would be a much better choice. Similarly, comparing the performance of a bond fund to that of a US Equity fund is also unreasonable because the funds have dramatically different compositions.
Related article: 5 things to know before choosing a mutual fund
When it comes to choosing investments, it’s much more important to ensure that your investments are in line with your goals and your risk tolerance because this limits your market risk and reduces the chance that you’ll be tempted to “sell low” when the markets take a downturn.
Remember the Uncontrollable Factors
There are a myriad of factors that contribute to a fund’s performance and the vast majority of them (market returns, economics etc.) are uncontrollable. This might explain why, statistically speaking, the chances of a top performing mutual fund continuing its “winning streak” for two years in a row are extremely low.
Related article: Chasing performance is the biggest don't to investing
When you consider that the one sure-fire way to make money through investing is to “buy low and sell high”, it doesn’t make logical sense to look for investments that are already priced high in the hopes that their value continues to rise. The idea of “chasing winners” appeals to the emotional side of our brain because it mistakenly sees the high returns as “proof” of an upward trend but, as an investment strategy, it more often leads to disappointment and frustration than to rich rewards.
Stick to the Basics
Investing isn’t rocket science and it doesn’t have to be complicated or confusing. At the heart of every investment decision are your goals, your time horizon and your risk tolerance. Taking each one of these into account narrows down the number of mutual funds that suit your goals. Keeping management fees low is your most tangible way to increase your investment returns so you can further narrow the field of suitable funds by focussing on funds with lower fees.
Related article: Low Mutual Fund Fees matter
Make an informed decision by doing a little research into your funds before you invest. Understanding the investments you have and knowing why you have them will put you ahead of a significant number of investors and that knowledge might well make all the difference when the markets take a downturn. Taking the time to do a little research and to boost your own understanding will help you avoid getting swept up in the usual tide of panic that tends to affect investors when they see statements showing negative returns.
Related article: 5 Investment research tips
As much as we’d like to believe there’s a magical “fast track” formula to making money from investments, the reality is that the majority of people who do well in investing, do so because they take a long term approach and apply a consistent strategy. As tempting as it might be, chasing winners and select funds based on high returns, it rarely pays off. In investing, as in so many other things in life, more often than not, slow and steady really does win the race.
What do you think?