There is a universally accepted concept in the investment world, at least on an academic level, that past performance is not indicative of future results. In other words, just because a stock or mutual fund has given 15% returns over the past five years does not mean that the trend will continue.
However, despite widespread acceptance of this concept, investors still tend to weigh past performance heavily when choosing investments. It is human nature to chase the trend, which is why so many people end up buying high and selling low, even in the world of mutual funds.
You can see this effect by analyzing change in Morningstar ratings and the subsequent flow of investments. According to a recent article in the Wall Street Journal, "Fund companies heavily advertise their star ratings. Money typically pours into funds after they receive a five-star rating from Morningstar, the Journal found. It flows out if they lose stars." So much for ignoring past performance.
So what does it matter? Investing in “five star” funds seems like a smart move, right? Well, according to that same article from the Journal, “Of funds awarded a coveted five-star overall rating, only 12% did well enough over the next five years to earn a top rating for that period; 10% performed so poorly they were branded with a rock-bottom one-star rating.” In other words, past performance is not indicative of future results.
If you are constantly selling “low rated” funds and buying “high rated” funds, you will, by default, constantly be selling low and buying high, which makes it difficult to come out ahead. So what should you do instead? Buy funds with low expense ratios and low turnover ratios from solid companies that achieve your investment objectives. “Stars” are subjective and more or less irrelevant.
The article later notes, “There is no question that Morningstar has greatly improved the transparency and rigor on mutual funds’ holdings and performance, making it easier for individual investors to compare funds.” So the key information about potential investments is out there—just make sure you don’t get distracted information that’s not.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.