Research says: Don't chase performance

It happens all the time. A mutual fund has an absolutely fantastic year or two, and new investors pile on the bandwagon, pumping in millions of dollars. Then the fund’s performance slips and disappointed unitholders leap off in panic. Most of them lose some money. Some of them lose a lot.

It’s so tempting to buy the previous year’s hot fund. But a recent study confirms that you’re better off if you stick with an investment plan that’s been well thought out.

Hot hands get burned
The study was conducted by Boston-based Financial Research Corporation (FRC). FRC found that from 1990 through 1999, the average U.S. mutual fund investor underperformed the average broad-based mutual fund by some 20%. U.S. mutual funds earned an average annual compound return of 10.9%, while their investors averaged only 8.7%.

Much of the performance lag was attributed to the tendency to buy hot funds at high prices and then dump them at low prices. Investors with financial advisors did better than others because they had less turnover.

FRC began the study by calculating the average fund’s returns for rolling three-year periods: 1990-92, 1991-93, and so on. The consultants then measured the extent to which people moved in and out during each three-month period by analyzing the average fund’s net flows — new investments minus redemptions. Not surprisingly, they found that funds attracted about 14 times more money at the end of their best quarters than at the end of their worst.

The firm also found that, even though mutual fund companies and financial advisors preach the value of long-term investing, investors don’t listen. The average holding period for broad-based U.S. funds was just 2.9 years. In 1996, it was 5.5 years.

Narrowed focus, bigger gap
The performance gap was even wider for specialty funds. For example, European stock funds averaged 14%, while their investors averaged 9.6%. Investors who moved into and out of financial services funds averaged 16.9%. That’s very good — but they could have made 25.7% just by sitting tight.

The gap was wider still for more esoteric specialty funds. The average emerging markets fund made 8.2%, while its average investor made 1.2%.

Interestingly, technology was one area where investors did fairly well — though they still underperformed their funds. The average U.S. tech fund returned 28.8%, while its average investor made 24.9%.

Note that this study did not take taxation into account. After tax, fund chasers investing outside of tax-sheltered retirement plans undoubtedly fared even worse than it appears on the surface.

The bottom line
The best way to build personal wealth over the long term is to establish a diversified portfolio that meets your investment objectives — and stick to it.