When it comes to investing, mutual funds are one the best known tools to help add diversity to a portfolio. Many people use a strategy of chasing after the top performing mutual funds and selling the underperforming ones. On the surface this makes sense. As a culture, we love winners, we don’t want losers. The winning mutual funds make the magazines. The losers… well not so much.
About that Past Performance…
When it comes to top performing funds, such as PIMCO Real Estate Real Return Strategy (PETAX) who showed one-year returns of around 25% percent or the Oceanstone Fund (OSFDX) which showed a three-year return of around 73%, the past performance is not a predictor of future gains. What you’ve heard that before? There’s a reason for that. Future gains are unpredictable and many of those top-performing funds are likely to have lower than average gains after a period of large growth.
Top performing funds only show a short-term historical track record. This short term growth does not always indicate continued growth in the future. Instead, it shows that the fund is currently at a higher price than previous years. Think of it this way, you are paying for a bunch of stocks that are priced much higher now than they were before. There’s a good chance that they are now overpriced and poised for a pull-back.
In addition the top performers are often high risk funds that are as likely to fall to the bottom of the charts within a year as they are to gain high profits. The high risk means that the funds are extremely unpredictable and it is possible to lose significant money as well.
Narrow Funds – Not Always Your Friend
Part of the high risk associated with top performing funds is the fact that the investment is extremely narrow. Instead of diversifying amongst different industries and countries, the fund puts the money into the same industry or country. For example, when gold does well, the funds that consist of gold will do well, when gold drops expect your investment to go with it. This lack of diversity means that if the industry as a whole increases, the fund is likely to have high gains and returns. Unfortunately, the same is true in the reverse.
The narrow choice of investments makes the fund riskier than many other fund options. Avoiding the high risk and opting for something more diverse is a key to increasing gains and cutting back on losses.
How to Improve Mutual Fund Gains
The key to investing and making more gains when working with mutual funds is avoiding the short term and seeking long term options. I’ve learned from experience that short term gains are not the best to chase because it is chancy and risky. In the end, chasing those short term returns results in higher losses that are difficult to make up later.
Instead, taking time to properly research the funds and find out how much diversity is included in the fund helps make a proper decision about which is best for long term gains.
I believe buying mutual funds based on the last year’s performance can be a mistake. Top performers are often risky funds that have limited diversity. Instead, well-researched funds that have a high level of diversity are better additions to the portfolio. Though the gains are often smaller in percentage, the risk of large losses is dramatically reduced.