Learn the Risks of Mutual Funds

Cigarette butts - don't burn your money the same way.
Past performance can be as dangerous to your wealth as cigarettes are to your health. Photo 24/Getty Images

Nearly everyone in the United States knows that smoking is not good for your health. Pick up any pack of cigarettes and you'll see the current warning,

What nearly everyone in the United States doesn’t know is that picking investments based on past performance is not good for your wealth. They don’t know this despite the fact that in any prospectus or investment that advertises performance you’ll see the warning “past performance does not guarantee future results”.

This investment disclosure has been so ineffective that studies have been done on its lack of success, such as the 2010 paper, Worthless Warnings? Testing the Effectiveness of Disclaimers in Mutual Fund Advertisements, which states that,

“Mutual fund investors flock to funds with high past returns, despite there being little, if any, relationship between high past returns and high future returns. Because fund management fees are based on the amount of assets invested in their funds, however, fund companies regularly advertise the returns of their high-performing funds.”

Another study published in the Georgia Law Review, Mutual Fund Performance Advertising: Inherently and Materially Misleading?, states:

“Funds' past performance might be the most important factor to investors choosing among equity mutual funds. Fund investors chase high past returns. Yet studies of actively managed equity funds have found little evidence that strong past returns predict strong future returns. Performance chasing is a fool‘s game.”

And in yet another study, Why Does the Law of One Price Fail? An Experiment On Index Mutual Funds, educated investors were asked to pick among four S&P 500 index funds (which all invest the same way in the same stocks). Participants were shown irrelevant statistics on past performance such as "inception to date return" – which is a useless statistic unless all the funds had started on the same date.

The right answer would have been to pick the fund with the lowest fees, yet a whopping 95% of participants got it wrong – and did not minimize fees.

Despite clear evidence that picking funds based on past performance is, frankly, a dumb way to pick investments, people keep doing it. Why? There is significant confusion about when past performance is and is not relevant. Below are three guidelines to use when thinking about past performance.

1. Past Performance Related to an Investment Manager’s Prowess Is Not Relevant

An investment manager can get lucky, or their particular style of investing may be in favor for an extended period of time. Good for them! That doesn’t mean it will be good for you. Irrefutable evidence shows active managers are not effective at earning returns higher than a comparable index.

2. Past Performance Related to One Fund Type vs. Another Is Not Relevant

For example, comparing a large cap fund to a small cap fund, or real estate fund to an emerging markets fund. Some asset classes do well in certain economic environments; some don’t. Picking investments based on past performance can skew you toward the asset classes that did well over the past five or ten years, which may not be the same asset classes that will do well over the next five or ten years.

3. Expected Returns From Risk Premiums Is Relevant - Over the Long Haul

I believe people confuse the above types of past performance with the expected returns that come from something called a risk premium.

For example, most investors believe that over time stocks should outperform safer investments like bonds. Past performance is often quoted as "proof" of this. However, it is not past performance that leads to the expectation that over time stocks should deliver higher returns than bonds. It is something called the equity risk premium.

The concept of a risk premium is based on common sense. Suppose you can put $10,000 in your local bank and earn a safe risk-free return of 1%. Or you can invest that $10,000 in a trusted friend's business. If the investment in the business was only expected to pay you the same 1% as the bank there would be no reason for you to do it.

You know the business could fail; you also know if it succeeds you will earn far more than 1%.

If you take on the business investment you expect a return in excess of what you could get in a safer investment - and you accept the risk that it could earn less or result in a loss. You make the investment because you expect to be compensated for taking on risk – that is the premise behind a risk premium.

It is this concept of a risk premium that gives certain asset classes a higher expected rate of return than others. And in most (but not all) cases, given enough time (20+ years) riskier asset classes have in fact delivered higher returns than less risky investment choices.

The expected returns from equity risk premiums is something entirely different than picking a mutual fund or trading strategy based on past returns.

The equity risk premium is a tool that can be used to build a portfolio of investments that have a higher expected return over long periods of time than other less risky options.

Using the equity risk premium concept to build a smart portfolio is an entirely different process than looking at a list of mutual funds and picking the ones that had the highest return over the past 1, 5, 10, or inception to date time period.

For your wealth, stop investing the dumb way. Start investing the smart way. If you don’t know how to invest smart, hire someone to help you. Fees paid for advice are worth paying. Fees paid for a fund that claims it can “outperform” the market are not.