The pitfall of choosing the top performing funds

With the advent of “do it yourself” investments, many investors feel that they can choose the right mutual funds for themselves rather than relying on advisors. They can simply download a mobile app (like Grow, Zerodha and others) and conveniently buy and sell mutual funds. Bypassing the advisor/distributor give them the advantage of lower expense load thus their return is likely to increase by 0.50-0.75% per annum. But is this benefit worthwhile for long term portfolio? We will examine this question in totality in coming articles, but in this article, we will see how most of these investors choose the mutual funds in the absence of expert advice-

It is observed that most of these investors turn to best performing funds of the recent past especially of the last 1 year. These mobile apps and many other such sites publish the names of top performing funds of the past year or two. In isolation, these returns look very very attractive. Investors feel that they have done a great reserch and end up buying these funds. But is this the right choice? Let’s examine 2 undeniable factors-

• The top performing funds are mostly lucky- Nobel Laureate Daniel Kahneman writes after a great deal of research in his famous book Thinking Fast and Slow that “the successful funds in any given year are mostly lucky: they have a good roll of the dice. There is a general agreement among researchers that nearly all stock pickers, whether they know or not- and few of them do- are playing a game of chance”.

Common investors expect that the top performing would either replicate its Steller performance or even if it won’t remain at the top, it will remain among the top few funds. But the problem is that, they are not rewarding the skill of the fund manager. Rather they are rewarding the luck which most of the time runs out next time. Even the skill in evaluating the business prospects of a firm is not sufficient for successful stock picking because future will always remain unpredictable.

• Regression to the mean- Like most other things in life, mutual funds also very strongly exhibit regression to the mean concept. As an investor you pick up the best performing fund of the last year only to see that this fund is delivering below average return in coming years. An average investor keeps on churning his/her portfolio in pursuit to find the best performing funds. But they are better off respecting the regression to the mean theory.

A study of Fortune’s “Most Admired Companies” finds that over a twenty years period, the firms with the worst ratings went on to earn much higher stock returns than the most admired firms.

The better approach is to make the portfolio based on your risk profile, investment objectives and time horizon. Basis these, set the right asset allocation and keep your portfolio sufficiently diversified.  For most investors, doing these activities objectively may be cumbersome hence staying with the advisor/mutual fund distributor should be the preferred route despite some cost.

Manoj Pandey

CFP
Mainstream Investments Services Pvt Ltd