That hot fund you just bragged about buying is unlikely to continue doing well. Indeed, we saw in the last chapter the sad record of the long-gone American Heritage Fund. That was the ultimate hot and cold performer of funds.

The hot fund of this year has about a one in twelve chance of repeating outstanding performance next year. That’s the warning of stock market pros, who say they see a constant pursuit of the newest investment stars by star struck investors. They warn that the average investor often chases last year’s hot fund. And that fund rarely repeats top performance. This leads to poor returns and disappointed investors.

“Investors should be wary of the hot fund,” says Richard Bernstein, a longtime money manager with his own advisory firm.

Let’s Look at the Record

S&P in a recent report examining a three-year period, documented how the hot fund idea is dangerous.

“At the end of the first year in September 2017, there were 545 funds considered to be top quartile. By the following year in Sept. 2018, just under 47% of those funds remained in the top quartile, and by the end of the third year, in Sept. 2019, only 8% were still in the top quartile,” according to the report by S&P Dow Jones Indices.

Nevertheless, many individual investors continue to make the same mistake. They become jealous when they see friends and neighbors rack up big numbers one year, or who say they have gotten great numbers (sometimes they’re making false claims). Then they chase hot performance, a market researcher warns, which is not the way to invest.

“They look at one year or three-year performance and make decisions based on that and that is the wrong way to do it,” says Aye M. Soe, one of report’s authors. Successful investors, she says, take a long-term view.

“One to three years is not enough,” she explains. “Look at five to ten years and look at the consistency of the fund. Has it outperformed over the long term?”

Once a Star, Now You’re a Bum

This year’s stars could be next year’s bums. In fact, it is very possible this year’s champs will be in the gutter next year. That’s because this year a manager might not have been brilliant; the manager might just have been lucky but next year the luck could run out, Bernstein adds.

The fund manager, he argues, “simply exposed the portfolio the most to what worked. That in no way means the underlying exposures will work in the future,” according to Bernstein.

And even well-meaning regulation sometimes can feed this hot fund mania.

“Those required one-year performance numbers, numbers that fund companies often prominently advertise, can mislead the investor,” warns Louis Harvey, president and chief executive officer of market observer Dalbar. He says companies are required, among other things, to post one-year numbers.

Bad Numbers

But beware, he adds, sometimes numbers can mislead. The investor, constantly seeking the hot investment by getting in and out of funds, can ruin a long-term return. This was documented in another recent study.

“In 2018 the average investor underperformed the S&P 500 in both good times and bad, lagging behind the S&P by more than 100 basis points in two different months,” according to a Dalbar study.

One hundred basis points is one percent and one percent can be a lot over the long term.

“In October, a bad month for the market (-6.84% S&P 500 return vs. -7.97% Avg. Equity Investor Return) the investor lagged by 113 basis points, while in August, a strong month for the market (+3.26% S&P 500 return vs. 1.80% Avg. Equity Investor Return), the Average Investor lagged by 146 basis points,” Dalbar said.

The Indecisive Investor

The investor should also remember that jumping in and out of funds triggers brokerage costs and possibly more taxable events. The costs add up over the long term. All this can hurt the bottom line of how much you receive in returns.

What should investors do?

Don’t be swayed by dazzling, often well-advertised, short-term numbers, the pros say.

Seek more than one year of strong returns. Expect consistency over a long term. How has the fund performed in bad times as well as good?

Winning over the Long Term

Harvey says examine fund performance over five or ten non-consecutive years. See what it did in relation to funds in the same category and against appropriate market yardsticks, one of those yardsticks could be the S&P 500.

Look for the fund that does well in the marathon, not one that just won the sixty-yard dash and has never won a race before.

Here’s the Name of the Game

Remember, you’re not investing to impress your friends or be the hit of a neighborhood cocktail party. You’re investing to achieve a goal. Here are some potential examples:

*Accumulating enough money for that first house

*Finding a way to finance a university education

*Achieving that much desired goal that eludes so many world-weary people who have been stuck in too many traffic jams or E-trains with “mechanical problems”: Financial independence.

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Gregory Bresiger
Gregory Bresiger

Gregory Bresiger is an independent financial journalist from Queens, New York. His articles have appeared in publications such as Financial Planner Magazine and The New York Post.