Performance chasing: Washing machines, cars, and mutual funds

Posted by on July 25, 2012 @ 1:00 pm in investing

Performance drives many of the decisions we make as consumers. What kind of gas mileage will I get? How big a load of clothes can the washing machine handle? How long will this roof last? For many of these kinds of decisions, past performance is a guarantee of future results.

Given its dominance in our buying decisions, it’s natural for us to consider performance when we’re selecting mutual funds. It’s hard to imagine (although it does happen) a car promised to go from 0 to 60 mph in eight seconds taking a whole minute to do so. Yet, with investments, expected performance can often disappoint.

We know from experience that a fund or sector’s trailing 12-month performance is a pretty good predictor of future cash flow, positive or negative. The key question is, do investors using that knowledge as a gauge actually see the performance they’re expecting? A few examples come to mind. Many of us remember the tech boom of the late 1990s. As all kinds of new technologies were being developed for commercial use—the internet not being the least of them—investors looked for ways to profit from this trend. Science and technology funds appeared to be among the most direct ways to invest, and cash flows increased steadily.

In February 2000, the category’s trailing 12-month performance was 179%, and cash flow into the group was $5.2 billion just for that month. As it turned out, that February marked the performance peak; the return for the next 12 months was -58%. Here’s another way to look at it. Every dollar that went into the category in February 2000 was worth only 42 cents a year later.

Emerging markets are another perennial favorite, albeit with a much less dramatic rise and fall. Monthly cash flows into the category for the five years ended December 2011 peaked in October 2010 at $11.2 billion. The trailing 12-month return at that time was 25.6%.

The Lipper Emerging Markets category average for the twelve months ended October 2011 had fallen 20.3%. Conversely, $1 invested into the same category average in February 2009 was looking at a 58% loss for the prior 12 months, but would have grown to $1.93 by February 2010.

My suggestion? Consider steering away from the siren song of fund performance and focus on the things you can control in the future: the role the investment will play in your portfolio and what you pay for it. Although “past performance is not a guarantee of future results” often appears in fine print at the bottom of the page, truer words are rarely spoken.

Data sources: Vanguard research and the Lipper Science & Technology Funds and Emerging Markets Funds Categories.

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