What mutual fund mistake am I talking about? This mistake is so common, chances are you have committed it yourself—before you became a savvy, successful investor, of course. If you have ever purchased a mutual fund solely on the basis of past performance, you have made this mistake. Buying yesterday’s winners—also known as performance chasing—is a time-honored tradition for many investors. No matter how many warnings they hear on the pitfalls of performance chasing, many novice investors continue to engage in this practice.
Poll your friends and family who have 401(k) accounts. Ask them how they decide which funds to invest in. I am sure you will find, as I do, that past performance plays a principal role in their investment strategy.
According to Dalbar, Inc., a financial services market research firm, performance chasing and other misguided investment strategies can cost investors dearly. For the 20-year period ending in 2010, the S&P 500 earned an annual average return of 9.1%—enough to turn $100,000 into $570,000. During that same time period, Dalbar estimates that the average equity fund investor earned a return of only 3.8%—enough to turn $100,000 into $210,000. Over a 20-year period, performance chasing cost the average investor $360,000 or 3.6 times his initial investment. Ouch!
A close cousin of performance chasing is investing in “star” funds. You know, the funds that the financial press lionizes—the Fidelity Magellan and Legg Mason Value Trusts of the world. This mistake isn’t limited to novice investors. Experienced investors and even some professionals are guilty of chasing star funds. Star funds tend to have strong long-term performance records when the financial press starts recommending them, but they soon become victims of their own success. Once the money pours in, the performance often turns south.
Take the Legg Mason Value Trust Fund run by Bill Miller. This was a darling of the personal finance magazines for years. Miller’s claim to fame was that he outperformed the S&P 500 for 15 consecutive years. But the streak ended in 2006 after investors dumped billions into the fund, and things quickly went downhill from there. Since year-end 2006, Miller’s Legg Mason Value Trust underperformed the market by 38%. Miller even lost his touch in his smaller, more nimble fund, the Legg Mason Opportunity Fund. Last year, Legg Mason Opportunity plunged 35%. Other star funds that bombed last year include CGM Focus, down 26%; the Fairholme Fund, down 32%; and Fidelity Magellan, down 11.5%.
The takeaway: don’t be a performance chaser, and steer clear of “star” mutual funds.
Jeremy Jones, CFA
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