How should you pick the best mutual funds?
- Best performer last year?
- Featured in a magazine?
- Outperformer over time?
Let’s consider the options:
- Last year’s best or maybe a long term outperformer: Looking for skill or outperformance means persistence of above average returns. There’s only one problem. Persistence is so rare that we would see more persistence if fund managers just flipped a coin for their decisions.
- Featured in a magazine: Bad, bad idea. See an unfortunate example of magazine stock picking. If at first you don’t succeed, fail, fail again–stock picking failed again. It’s especially bad if the fund manager or CEO is on the cover.
- Long term outperformer: Sorry, almost no mutual funds outperform the market over a 5 year period.
- Active management is even worse than it looks. Survivorship bias is caused by Fund management companies hiding their failures from the statistics by merging them into more successful funds.
The correct answer is: none of the above–choose a low expense ratio index fund.
- A mutual fund trying to outperform the market, has an 80% chance of failure.
- What can we say about the alternative, a “boring” index fund? It averages a return that is 2% higher than managed funds. E.G. making 10%, vs. 8%. Expense Ratios are a big deal, maybe the biggest, in choosing the best investment.
