Past Performance Does Not Guarantee Future Results

My thoughts on investing in mutual funds.

Part I

I just finished reading a lengthy newspaper article about a certain money manager, a fellow who founded an investing company and offered mutual funds and similar investments to wealthy people looking for profitable places to put their money.  I won’t mention his name because his name doesn’t matter.  If I were writing this a few years earlier it would have been some other money manager.  A couple years from now, and it will be yet another money manager.

The story is always the same.

In this particular case, it started about a decade ago.  This particular man got lots of people to invest their money with him, based on whatever his particular investing ideas and strategies were and what the economy was doing at the time, … and … it paid off, in a big way.  The investors got huge returns and our money manager earned a lot of money for himself.  Everyone was happy.  Our money manager was featured on the cover of the personal finance magazines.  He was the golden boy.  Everyone (or, so it seemed) thought that he was THE one.  He had it all figured out. He knew what to do.  He couldn’t lose.  What would he do next?

Then, times changed.  Contraction became recovery.  Recovery led to expansion.  The crisis in this industry or that sector ended.  Some other industry becomes the next big thing.  Or the opposite happens.  Then something else happens.  Or doesn’t happen.  The economy evolves.  Or doesn’t evolve.  Things continue to happen.  In other words, the world goes along much as it has for the past several thousand years.  Our money manager now finds that the huge returns have become losses. Shares in his special mutual fund that used to increase in value by 20, or 30, or 50% every year are decreasing in value each month.  His much touted new offerings lose value immediately.  Then comes the article in the newspaper.  This man used to be so great.  Now everyone’s wondering if he can turn it around.  Can he change losses to gains?  Can he be great again?

Past Performance Does Not Guarantee Future Results.

If you read about investing long enough, you see the same story over and over. Only the name changes.  The star money managers of last year are replaced by this year’s new stars, who, in turn, will be replaced by next year’s stars.  They come and go as quickly and regularly as pop stars loved by teenager fans.  You don’t even need to read to observe the spectacle.  Just look at the covers of the personal finance magazines and note the names of this year’s stars.  Wait and see if you ever hear of them again.  If you do, is it because they’re still succeeding, still beating the market?   Or is it because they’re the subject of an article like the one I mentioned above?

Many money managers can, and do, beat the market (that is, obtain investment returns that are better than the average of the entire stock market as a whole) for a year, maybe a couple years, perhaps even a few years.

investing_for_profitWhat tends to happen to almost all of them, though, is this: They have a few good years, a few bad years, a few average years, and then more of the same.  Over time, it’s generally the case that most money managers do about as well as the market as a whole. It’s basic mathematics: Generally, the average of a set of numbers is the average because many of the numbers in the set are equal to or near to the average.  In other words, the average is the average because it’s typical.

Mutual fund companies are sometimes pretty sneaky too; if a particular fund has done particularly poorly, it often ceases to exist.  It gets liquidated, merged with another fund, and is soon forgotten, much like the way some Soviet leaders got  airbrushed out of memory once they had fallen from favor.  Getting rid of under-performing funds raises the average of a company’s remaining funds, making it appear that all of a company’s offering are “above average” like Lake Wobegon’s children.

There are a very few money managers who can consistently beat the market year after year for decades. If you want names, here are a few: T. Rowe Price, Jr.; John Neff; Peter Lynch; and of course, Warren Buffett.  Let’s say that these, and a few more like them, are the real geniuses among money managers.

But let’s remember, these real geniuses can only be identified in retrospect.  At the start of their careers, how many investors correctly perceived how successful Lynch, Neff, Price, and Buffett would eventually become?  Were any of the investors of the 1940s, 50s, or 60s so confident that they invested ALL of their money with one of these geniuses?  I doubt it.  Most likely, the people who invested with T. Rowe Price or Warren Buffett when they were just getting started also had other investments.  In other words, they diversified their investments.  That’s financial for “don’t put all of your eggs in one basket”.  Because they diversified, some of their investments yielded huge returns, others didn’t do as well.  Maybe there were some losses that were offset by the large gains.  For many of them, maybe most of them, the bottom line probably showed returns that were pretty close to the market as a whole.

Because we can’t accurately predict the future, I think we have to accept as a given that there’s no way to say today which of today’s money managers will be the geniuses of decades to come.  Much like the investors of previous decades, all we can do is diversify.  This means investing in several different mutual funds.  Do this, and  you will probably have a few investments that do better than average, a few that do worse, and it will all even out … you will do as well as the market as a whole.  This is especially likely over the span of decades.

Doing as well as the market as a whole — it’s not like that’s a bad thing.  Doing as well as the market as whole is pretty good.  Save and invest consistently throughout your working life, earn 5, or 6, or 7% per year on your investments, on average, over a long time, and you have an excellent chance of being able to retire happily.

Part II

But wait! There’s one thing I haven’t mentioned yet.

It’s this: Money managers are expensive.

They, and their staff of assistant money managers and other related financial experts, don’t work for free.  They get paid.  Their salaries, bonuses, and other expenses to keep them working are charged to the investors or come right out of the money people invest.  Mutual funds come with various fees and “loads” (purchase fees, redemption fees, exchange fees, management fees, service fees, etc.).  Added together, they take quite a bite.  The ongoing management fees are often more than 1% of the fund’s assets, paid every year.  That percentage (“just 1%!”) might not sound like much, but over time it reduces an investor’s earnings significantly.  A mutual fund that earns average (that is, equal to the market as a whole) returns “on paper” actually gives its investors less-than-average returns once the various fees are deducted.

The only way all those fees can be justified is if the money manager consistently delivers significantly higher-than-average returns.  As explained above, most money managers can’t deliver … and, looking ahead, it’s just as impossible to select the mutual fund with the money manager that will outperform the market consistently for decades as it is to predict the future.

What’s needed is a way to get average returns and pay the lowest fees possible.  Question: Are there mutual funds that (almost) don’t charge any fees?  Answer: Yes.

Passively-managed index funds.

To understand what passively-managed and index mean, let’s compare them with the actively-managed funds that we’ve looked at above.  Actively-managed simply means having a staff of money managers who are actively making decisions as to what stocks a fund should buy and which to sell.  That’s the traditional job of a mutual fund’s manager.  Money managers employ a basic investment philosophy for the mutual funds under their management (“growth”, “income”, or “value” for example), but they freely buy and sell stocks as they see fit, given their view of economic conditions and so forth.

Compare the traditional actively manged mutual fund with the passively-managed fund.  Instead of having a money manager making day-to-day buy-and-sell decisions, the passively-managed fund follows an explicit formula.  Generally, this means investing only in companies that are part of a certain stock market index.  The S & P 500 is one example of a stock index.  You might think of it as basically the 500 largest American corporations.  (Actually, it’s a little more complex than that; companies are selected for inclusion on the index such that the index is representative of industries in the United States and other additional factors are also considered.)

(Stock market indexes, and there are many, are separate from mutual funds.  They were originally created as a way of gauging the overall health or direction of the stock market.  These indexes have been around longer than mutual funds.  One of the oldest is the Dow Jones Industrial Average, which has been extant since the late 1800s.  No one thought of creating a passively-managed mutual funds based on stock market indexes, until some decades after actively-managed mutual funds became a common way to invest in the stock market.  John Bogle, who deserves the title of real genius as much as anyone, is known as the man who first popularized index funds for average investors.)

The important part: Passively-managed mutual funds are much less expensive to operate than actively-managed funds.  Why this is so is simple: No need to pay for expensive money managers.

Because a passively-manged fund tracks a given index, it earns average returns pretty much by definition.  If you want the average returns of the S & P 500 index, then you buy shares in an S & P 500 mutual fund.  If you want the average return of the entire U.S. stock market, there’s a fund for that.  There are many others as well.

The fees charged by a passively-managed fund are significantly lower than those charged by actively-managed funds.  This means more of your money is working for you, instead of paying a money manager and his staff.  Over a period of decades, the difference is significant.  Like many thousands of dollars of difference.

Don’t just take it from me.  Do some research.  Learn more about index funds.

If you want a hint, here’s one word:  Vanguard.


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