At this time of year, you can take a look at the newspaper, financial magazines and of course the internet and you will find a plethora of the ever popular ‘best and worst' lists of the year 2000.
You can rank and rate funds to determine the top and bottom funds of any fund category (equity funds, global funds, bond funds), for any time frame (5 years, 3 years, 1 year and even by the month or day) and for any company.
Investors use these lists over and over to try to make solid, informed decisions on where to put your money for your RRSP contribution. But do these lists really help us to make good investment decisions?
Good or bad?
Let's start by taking a look at the top 10 and bottom 10 funds for 2000. The best fund in 2000 was the Talvest Global Health Care Fund with a 1-year return of 108.4%. The worst fund was the First Trust Dow Jones Internet Tr 1999 with a return of -65.8%.
By nature of this example, does the 1-year performance of these two funds make them good or bad funds? The answer is simple . . . you cannot make that conclusion from this limited amount of information.
Yet, time and time again, investors use these top and bottom lists to try to make conclusions about what is good and what is bad. Our ‘investor psychology' leads us to believe that because a fund has done the best last year, it will continue to be the best in the future. And, of course, if a fund has done the worst, it will continue to do the worst.
The reality of chasing performance
If you are reading this article and you have just made your RRSP investment with one of last years winners, do not feel too bad. You are not alone. Our research says that there is a greater than 90% correlation that last year's best performer are this year's best selling investments. Far too often, investors will buy last years winners.
Yet, what is more important is to know if there was a correlation between last years best performing investments to this years best performing investments. Unfortunately, there is less than a 10% chance that last year's winners will be this years winners. Those are really bad odds.
What do these lists tell us?
- Firstly, these top and bottom lists tell us about the past. Remember that past performance is no indication of future performance, especially over short periods of time. It baffles me when investors look at the best and worst over the course of a year or a month and even a day. Short term movements in the markets and mutual funds are random. Hindsight is easy but nobody knows what investments will go up or down in the future.
- These lists cannot tell us if an investment is good or bad. What they do tell us is that these funds are usually the riskiest. Funds that make the top or the bottom require a certain amount of risk to get there. Take the top and bottom 10 for 2000 for example – they are all regional or sector specific funds. All of these funds have higher standard deviations (risk). Rarely will you find core, conservative, stable, consistent funds make the top or bottom lists. So the next time you pick one of these funds among these popular lists, ask yourself how much risk you want to take.
- These lists also give us an indication of what will not be the top or bottom in the following year. There is a 90% chance that these funds will not repeat in these lists.
- Finally, these lists really tell us very little! Choosing based on performance and performance alone is no different than choosing to buy a car because of color and color alone – for example red. You do not care about the age, quality, brand, engine, fuel economy, options, etc. When evaluating the quality of a mutual fund, you must take into consideration and number of factors; one of which includes performance. Be sure to understand other dimensions like risk, management fees, management style, fund objective, consistency, etc.
In the end, good research leads to good decisions. Choosing from performance and in particular choosing from these top and bottom funds lists is poor research.