Saturday, December 10, 2011

Investment Performance Persistence Improbable

Standard & Poor's released their most recent S&P Persistence Scorecard.  It clearly shows why it makes no sense to pay someone to pick "good" mutual funds for you (or for you to try to pick funds yourself).  It's easy to find plenty of mutual funds with terrific track records in the PAST, but nearly impossible to identify funds that will outperform index funds in the FUTURE.

The problem is funds with great track records rarely give a repeat performance.

The study looked at a 10 year time period. First, they identified the top 25% of mutual funds for the first 5 years. Then, they looked to see what percentage of that top 25% stayed in the top 25% over the next 5 year period.  Here is a summary of the results:

  • 12% of large-cap funds with a top-quartile ranking over the five years ending September 2006 maintained a top-quartile ranking over the next five years.
  • Only 3% of mid-cap funds and 20% of small-cap funds maintained a top-quartile performance over the same period.
You may be thinking there may be a glimmer of hope in picking small cap funds that can give a repeat performance (20%).  But, as S&P points out, random chance of picking a fund that falls in the top quartile (top 25%) is of course 25% (by definition).

Thus, if you, or your investment advisor, picks only funds that have outperformed in the PAST you actually reduce your odds of picking an outperforming fund compared to a random guess!

Combine this study with S&P's previous study that shows index funds repeatedly whip active managers and the answer is crystal clear. The best thing investors can do is buy index funds.

So, the next time you walk into your local bank and their hot shot salesman investment advisor asks you to pay him 1% per year to place your money in his impressive list of mutual funds he has hand picked, all with stellar track records - simply turn on your heel and walk out.

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