Why buying five star mutual funds is hazardous to your wealth

Many mutual fund investors believe that buying the highest rated funds is a good way to invest.  It actually is a very poor idea, and it is likely to lead to, at best, mediocre performance.  Why?  Because investors who buy such funds are buying at the wrong time.

One of the first rules of successful investing is to buy low and sell high.  This of course is much easier said than done.  No one really knows whether low is really low and whether high is really high until well after the fact, when it is too late to do anything about it.  There are two additional corollaries to the “buy low and sell high” rule that should also be put into practice: don’t buy high and don’t sell low.  Investors who buy five-star funds violate the “don’t buy high” portion of this rule.  Mutual fund ratings reflect their recent performance.  The five star funds have recently performed better than most other funds, and are therefore priced relatively high.

Investors who purchase such funds are implicitly making the assumptions that “the best” funds will continue to be “the best” and the remaining funds will continue to lag.  They are assuming that past performance is a good indicator of future results.  Virtually every mutual fund advertisement clearly spells out that past performance is not a guarantee of future results, but investors who blindly purchase only the highest rated funds have not internalized this message.

A huge barrier to fully understanding this important concept is that past performance is a very good indicator of future performance in most other areas of life.  The smartest kid in fourth grade will probably be at the top of her class in fifth grade. The dog that wants to retrieve a ball today will also want to tomorrow. The weather in your hometown next summer will likely be similar to what it was this past summer. The Chicago Cubs did not win the World Series last year and won’t win it this year, either. Your Democratic congressman is not going to start recommending that everyone should listen to Rush Limbaugh.

This rule about past performance does not apply to financial markets, though.  Before 2008, national residential real estate prices not declined since the Great Depression.  Earlier in the 2000 decade, many people had made the erroneous assumption that real estate prices would never decline, basing that assumption on past performance.  They purchased over-priced assets and later suffered the consequences when the trend dramatically changed.

Stock price trends do not continue forever, either, so buying past winners is more likely to be a losing strategy than a winning one.  Imagine for a moment an alternative universe in which five-star funds actually did continue to perform better than all other funds.  How would this play out? A five-star fund by definition is in the top 10 or 15% of all funds in its class. As the five-star funds outperformed, this would get noticed and reported by the financial press. Many investors would see that there is an easy way to riches, thus increasing numbers of people would buy those funds. Before long, virtually everyone would own just the five star funds, which continually outperform. But what would they outperform? No one would own anything else. This defies logic; therefore, something must be wrong with the initial assumption. Everyone cannot be in the top 10%, by definition.

The bottom line is that buying the best performing funds of the recent past is not a well-informed and intelligent decision.  It is based on an erroneous assumption that past performance is a good indicator of future results.  Investors will need to look elsewhere to find a low-effort way to outperform the market.

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