Shopping lessons

Posted by on November 26, 2013 @ 11:15 am in Personal finance

When I was growing up, the shopping authority in my family was Consumer Reports. As we shopped for cars, washing machines, or cassette players with Dolby stereo, we’d wield the magazine like a talisman to protect us from lemons.

If I wanted a tape deck that could eliminate the hiss from my 8-tracks, I shopped among those that had eliminated the hiss in lab tests. Billy Joel never sounded so good.

A crack in the rearview mirror

When I began to shop for mutual funds, I approached the task with the same mind-set. To find funds that would make me rich, I simply had to identify those that would have made me rich in the past. It seemed so easy.

Soon enough, of course, I learned the truth behind the boiler plate: Past performance is no guarantee of future results.

This surprising reality is apparent in the table below, which comes from the Vanguard research paper The case for index-fund investing. Vanguard looked at the 20% of U.S. stock funds—”the top quintile”—that had generated the best returns relative to their benchmark indexes for the 5 years ended December 31, 2007. The researchers then tracked the performance of those same funds over the subsequent 5 years.

Quintile ranking in subsequent 5 year period ended 12.31.12

Notes: The first two columns rank all active U.S. equity funds within each of the Morningstar style categories based on their excess returns relative to their stated benchmarks during the period cited. The shaded columns show how the funds in each quintile performed over the next five years. Sources: Vanguard and Morningstar, Inc.

If past performance were a reliable guide to the future, you’d expect most top-quintile funds to remain in the top quintile. If it told you nothing, you’d expect the top performers to scatter more or less equally across all five quintiles in the subsequent period.

The second pattern prevailed. In fact, the reality was a bit worse. Only 14.9% of the onetime champs remained top-quintile performers in the subsequent 5-year period; 24% delivered bottom-quintile performance; and 16.8% disappeared, a bad outcome regardless of returns before the funds’ extinction.

Investing truths

Maybe you can’t shop for mutual funds in the same way that you’d buy a toaster. The past nevertheless provides useful insights, though they’re more subtle than simple lists of best and worst performers.

Most important, the relative returns—and risks—of broad asset classes have proven more predictable than the returns of individual funds.

  • Stocks have offered the highest potential returns, but with the greatest risk of declines.
  • Bonds have offered more modest potential returns, but more price stability, which can help diversify a portfolio of stocks.
  • Money market funds and other savings vehicles have offered the lowest potential returns, but the greatest price stability.

We expect these patterns to persist. The most reliable way to capture the characteristics of these asset classes is to diversify broadly across each.

The past also reveals another lesson: If there’s one signal that has been better than others in identifying which funds will outperform the pack, it’s cost.

Whether it’s index funds targeting similar market segments or actively managed strategies with similar strategies and objectives, you can enhance your chance of picking “the winner” by choosing the low-cost option.

That guideline deserves a place at the top of your shopping list.

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