Conventional Wisdom is Wrong When It Comes to Picking Mutual Funds
At 16 years old, the mother of one of my friends loaned me a copy of a wealth building course she purchased by Charles Givens. I was so interested I read the entire thing from front to back. What really caught my interest was the section on mutual fund investing. I must have read a half dozen similar books over the next year. Shortly after turning 18, I met with a broker from Primerica and started investing monthly in mutual funds.
I spent the next 10 years doing what conventional wisdom taught was the right way to invest in mutual funds. I bought funds managed by the top companies in the industry like American Funds, Fidelity, and Van Kampen. I picked funds with long term track records and great returns. I increased my monthly contribution every year and I never withdrew any of the money. I also invested in several different funds so I would be 'diversified', and if MorningStar said my fund got five stars, how could I go wrong?
10 years later I had over $40,000 in my account. This may seem like a lot of money, but it doesn't represent a lot of organic growth. The returns I was getting weren't much better than what I could have got investing in CDs. This is when I ran across a local radio show called 'The Investor Coaching Show'. A man named Paul Winkler was teaching listeners how to invest the right way.
Even though Paul has an entire alphabet of letters behind his name, (AAMS, RFC, LUTCF, CLU, ChFC), I thought he was a complete idiot. He taught that conventional wisdom was wrong when it came to investing. The first time I heard him tell a caller that picking mutual funds with good past performance was not a good criteria for successful investing, I nearly choked. If you don't look at past performance then what should you look at?
It took me nearly a year of listening to Paul to finally admit that conventional wisdom wasn't working for me. A few weeks later, I scheduled an appointment with Paul and made the decision to take his investor coaching course. Paul helped me to realize the truth about investing. What I learned made me realize much of what is considered conventional wisdom is little more than myths. Working with Paul turned out to be the best investment in my investor education that I have ever made.
DISPELLING THE MYTHS
Myth
Investment advisors can consistently and predictably add value by exercising "superior skill" in individual stock selection.
Fact
If you compare the performance of managers of large U.S. blend funds against the S&P 500 for 1994- 2003, the results are very telling. Not one single manager was able to beat the S&P 500 index for all 10 years. There wasn't even one manager able to beat the S&P for 9 out of the 10 years or even 8 out of the ten years. 72% of managers were only able to beat the S&P for 2 - 4 out of 10 years. If you picked stocks by throwing darts at a dart board you would produce similar results.
Myth
Finding funds that did well in the past is a reliable method of indicating which funds will do well in the future.
Fact
If you examine the top 20 funds from 1984 - 1993 and compare them to the top 20 funds from 1994 - 2003, how many funds do you think made both lists? There isn't one single fund that made both lists. The top funds of today are never the top funds of tomorrow. This is the best indication that past performance is no indication of future results.
Myth
Money managers are able to utilize market timing to effectively predict up and down markets.
Fact
Over the ten year period ended June 30, 2002, there were 2,521 trading days. If you were fully invested in the S&P 500 during this period, your rate of return would have been 11.4%. What do you think would happen if you weren't invested during the 10 best days of this period? How much do you think your return would have dropped?
By missing just the 10 best days from this period your return would have fallen from 11.4% to 6.7%. If you remove the 40 best performing days your return would have fallen below 1%. Do you really trust a manager to predict when is the best time to move in and out of the market? If he /she were wrong just 10 days out of more than 2,500 your return would have been cut in half.
Myth
What you don't see can't hurt you.
Fact
Mutual funds are in the business of making money. They make money by charging fees to their investors. Mutual funds are required by law to disclose the fees they charge. What I learned is there are more costs involved than what is disclosed in the prospectus.
If you have ever purchased an individual stock, then you are probably familiar with the terms bid price and ask price. All stocks have a bid price and an ask price. The bid price and ask price are never the same. The ask price is always a little higher than the bid price. This difference is known as the spread.
What this means is if you are buying stock you pay the higher ask price and if you are selling the stock you receive the lower bid price. Mutual funds are no different than anyone else. They are subjected to this same fee as the rest of us. The more a mutual fund buys and sells stock, the more money they loose to the spread. It is estimated that the average mutual fund looses more than 3% every year to the spread.
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Tags: investor coach, mutual fund investing, paul winkler, picking mutual funds
Brent,
Thanks for your mentioning my influence on your thinking. The fact that you started so young in your pursuit of investing is impressive.
Unfortunately, the investing industry has a big vested interest in investors believing many of the myths dispelled in this article. The fact is that investors believe that the investment world works like virtually everything else in their lives – namely, that past performance is an important criteria for judging future performance. Think about it. If you want to judge who will perform well in college, you would look at their high school transcripts. The same is not true in the world of investing because good past performance is more of a function of luck, not skill. If it were skill, we would find more persistance among managers. In other words, their success would be repeatable. The evidence is to the contrary.
So how does one invest? By focusing on successfully capturing the returns that markets tend to deliver over time. Quite simply, the capital markets exist to bring people in need of money together with people who have money to invest. It is not the job of the advisor to try to outperform the returns that different areas of the market deliver. Their job is to make sure that every investment vehicle used is as efficient as possible in delivering those returns to the end investor.
Paul Winkler, ChFC
Accredited Asset Management Specialist
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