You aren’t good at picking mutual funds!

Ramit Sethi · April 20th, 2005

Remember when I wrote about how foolish actively managed mutual funds are in most cases? (Link: Don’t some active mutual funds beat index funds?) I’ve also written broadly about mutual funds: All about mutual funds

Anyway, in those articles, I pointed out in 9/10 cases, buying an actively managed mutual fund is a sucker’s game. I suggested index funds as a better way to start investing.

Now check out what Jonathan Clements, the fantastic personal-finance writer from the Wall Street Journal, has to say.

Suppose, at year end 1969, that you had ranked diversified U.S. stock funds based on their 10-year performance and then bought the top 25%. Result: Over the next 10 years, you would have lagged behind the S&P 500, according to calculations using Lipper data by the Bogle Financial Markets Research Center in Malvern, Pa.

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Similarly, the top performers from the 1970s were stock-market laggards in the 1980s, and the top performers from the 1980s fell behind the S&P 500 in the 1990s. And the current decade isn’t looking too good, either. The top 25% of stock funds from the 1990s have fallen 5.2% a year during the past five calendar years, trailing the S&P 500’s 2.3% annual loss.

In other words:

  • We are very, very bad at choosing mutual funds (just as we are generally bad at picking stocks, actually)
  • Past performance is no indicator of future performance. Yes, every fund writes this on all their ads, but everybody pooh-poohs it and doesn’t really care. IT REALLY IS TRUE.
  • Buying an actively managed fund (where you’re paying 2-3% for someone to manage your money) cuts into your profits even more, making it unlikely you’ll even beat the market (a relatively dim goal for sophisticated investors). Remember, about 85% of actively managed mutual funds fail to beat the market.

Although I drill this point in my classes, it seems that the best audience for this advice is your parents–and we all have parents who are in actively managed mutual funds. Talk to them and you’ll be surprised what they know about their own investments!

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  1. Andre Nyffeler

    I agree that on the whole index management outperforms active management. I also understand the excerpt and agree that index funds are generally the best way to start investing. However, I also think it’s realistic for someone to do some due diligence and pick a mutual fund that is likely to outperform its benchmark.

    Many studies support a lack of persistence in mutual funds for all but the worst performing mutual funds. ( However, much recent research has supported persistence in mutual funds, particularly in the following article.
    Do Winners Repeat with Style by Roger Ibbotson
    “Our data of domestic equity mutual funds indicates that winning funds do repeat good performance…the highest persistence is exhibited by funds whose alpha is greater than 10% and also by funds whose alpha ranks in the top 5% of the sample.”
    This is a recent paper (2002) by a definitive researcher (sold his financial information firm to Morningstar for tens of millions and is highly regarded by his peers and the industry).
    In essence, I agree with everything you said but would like to add this relevant and potentially harmful info.