You read right.  Millions of investors guarantee their failure by
selecting mutual funds and stocks based on quarterly or annual 
performance records.  Do you chase performance?  You might be 
buying high and selling low!
  
As the year draws to a close, millions of mutual fund investors 
begin an annual event to divine next year’s winners.  Yet most of 
these individuals rely heavily on a time-honored – but terribly 
wrong – method of evaluating strength.  Whether analyzing 
screening tools from websites, reviewing fund honor rolls in 
magazines, or using star ratings from fund analysts, normally 
savvy business people foolishly chase the returns of last 
year’s hottest investments.
  
This begs the question: Can top performing mutual funds lead 
two years in a row?  Consider a study commissioned by Vanguard 
Investments Australia and released by Morningstar.  The five 
best performing funds were analyzed from 1994 to 2003.  Here 
are the results:

 --  Only 16% of top five funds make it to the following year’s 
     list.
 --  Top five funds average 15% lower returns the following year.
 --  Top five funds barely beat (by 0.3%) the market the 
     following year.
 --  21% of all top five funds ceased to exist within the 
     following 10 years.


Academic studies and market statistics confirm the typical 
investor acts in direct opposition to the sage advice – buy low, 
sell high. It’s only after high returns are realized and reported 
that investors pour money into both stock and bond mutual funds.  
In fact, Financial Research Corporation compared investor cash 
flows into mutual funds.  Purchases immediately following 
best-performing quarters exceed 14 times those immediately 
following their worst-performing quarters. In other words, you 
are 14 times more likely to buy funds at their highest price 
than at it’s lowest.  Buy high and sell low.

Just what kind of damage are they inflicting to their investment 
returns? DALBAR, Inc., conducted a well-known study called 
Quantitative Analysis of Investor Behavior.  The study confirms 
investors’ poor timing and the resulting financial carnage. 
Investors buy funds immediately after a rapid price appreciation.
This just happens to be right before investment performance 
wanes. Prices fall soon after and the investors quickly dump 
their holdings to search for the next hot fund. The resulting 
returns fail to even beat inflation!  When measured over the 
last nineteen years, the average equity investor earned a meager 
2.6% annual return.  Compare that to a 3.1% inflation rate and 
a 12.2% return from the S&P 500 over the exact same time period. 
Not only did investors fail to keep up with the market, they 
also lost money to inflation.

We’ve all seen the warnings on packages of cigarettes. Even 
smokers understand their relevance; smoking is not a healthy 
activity.  So why do investors not heed warnings about mutual 
fund returns?  You’ve all seen those statements too.  But can 
you remember what is said?   Past performance is not a guarantee 
or indicator of future results.  Research and studies have 
proven this fact, yet the majority of investors choose to ignore 
this warning. Yes, it’s an easy means of comparing funds. It 
also happens to be completely irrelevant.  Let me evangelize 
these words for you. Past performance does not predict future 
results!
 

Here’s how you can stop chasing short term performance and stay 
focused on your financial goals. Identify appropriate long-term 
investments by evaluating the following:

 -- Group leadership:  
      How does the fund perform relative to similar size and 
      similar style funds?

 --  Management tenure:  
      How long have the managers and advisors been at the fund?

 --  Management skill:  
      Are managers well-known and highly-regarded (e.g. remember 
      Peter Lynch)?

 -- Consistency of returns:
      Are the 3, 5, and 10 year returns all above average?


Finally, measure returns based on your entire portfolio. History 
shows that no single investment success repeats. Accept the fact 
every year is different and brings new leaders and laggards.  Use
an asset allocation strategy to guarantee balance and increase 
long term returns among all your investments. Invest in a 
diversified portfolio to meet your financial goals — and stick 
with it.

Not yet learned your lesson? Consider this: Fourteen mutual funds 
topped the 2003 charts with returns over 100%.  In 2004, these 
fourteen funds lost over 4% while the S&P 500 gained over 9%.  
Congratulations, chasing performance lost 13% of your money this 
year. 

Tim Olson
http://TheAssetAdvisor.com
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Mr. Olson is the editor of The Asset Advisor, a financial 
investment service providing proven strategies for no-load mutual
fund investors. He brings 26 years of education and experience 
from Stanford University, Ernst & Young financial consulting, 
personal wealth management, and venture capital investing.