The Immense Stupidity of Investment Selection

You’ve seen the headlines.

“Five 5-Star Funds to Watch in 2023.”

“This Top-Performing Fund is Shooting Out the Lights!”

“Ten Mutual Funds Poised to Outperform.”

The Financial Pornography Network is obsessed with investment selection. More than the general rise and fall of the market or economic forecasts of the future, they love to write about specific companies or funds and prognosticate their potential. And because financial “journalism” cares so much about investment selection, so do we.

Investment Selection is the specific companies, debts, or funds we invest in. We talk a lot about broader financial planning and principles of investing at RetireMentorship. Those principles are great and inform how we should invest. But at the end of the day, we need to select a definitive investment or set of investments, with ticker symbols, to invest our hard-earned cash.

How should we select our investments?

The media’s focus on it may lead us to believe it is critical to select our investment immediately. They encourage us to select popular funds, highly-rated funds, or whatever they (erroneously) think will “outperform” in the future. Let’s set the record straight.

Last week we looked at where investment selection fits in the financial planning process. If you missed that, pause this and listen to that first. Then come back to Investment Selection.

First, we’ll examine how not to choose your investments. We’ll wrap up by exploring the principles for choosing your investments. We’ll never tell you where to invest on a podcast because we can’t, and won’t, give investment advice to the general public. But educational principles are always helpful.

Investment Selection the Wrong Way

Here are three bad ways to select investments.

Investment Selection by Past Performance

Far too many people choose their funds based on past fund performance, specifically recent performance. It is mind-numbing just how dumb this idea is. Let me tell you a story to illustrate the point.

The Perfect Investment

It was the “Lost Decade.” The timeframe was the years 2000 through 2009. The stock market and nearly all equity funds were generally flat or down in value over this ten-year stretch. (It’s pretty easy to find extended periods of loss when you measure from the top of an inflated bubble to the bottom of the subsequent crash, but I digress.) I say “nearly” all equity funds were down, not “all.” One fund, in particular, did quite well.

From 2000 through 2009, CGM Fund’s Focus Fund returned a whopping 18.2% per year. If you had invested in the fund in 2000 and stayed invested throughout, you would have more than sextupled your money in ten years, during which the S&P 500 had lost money. It was a staggering achievement!

Behavior > Selection

This story has two morals, the first of which I’ll introduce now. During that period, when the investment fund had averaged 18.2% per year, the average investor in that fund averaged -11% per year. You read that right. Not 11% per year, as in they performed 7% less than the fund. Negative eleven percent.

The asset allocation was 100% equities. The fees were irrelevant based due to its vastly superior return (almost everything else was negative, and the next closest competitor averaged “only” 14.8%, which would have “only” quadrupled your money). This was a perfect investment selection for the time.

But the behavior of most investors was utterly flawed. They jumped in after the fund had grown (investing based on past performance) and jumped out after the fund went back down (assuming potential performance would continue to fall).

The first moral of the story is this: It doesn’t matter how perfect your investment selection is if your investment behavior fails. We must stop focusing so much on investment selection and focus much more on investment behavior. We are better off selecting and sticking to investments that are sub-optimal in retrospect than trying to pick the best-performing funds and continually botching the timing.

Past Performance Means Squat

For a decade, the CGM Focus Fund was the best-performing fund in the market, and it wasn’t close. We’re not talking about a one-hit wonder that was the top-performing fund for a year or two. The Focus Fund reigned supreme for a decade, which many people would consider “long-term.” Isn’t that enough past performance to indicate future return? Isn’t that enough data to select and stick to the fund for good?

CGM Funds is now defunct. That’s right. In November of 2022, CGM Funds, the manager of the best-performing fund of the Lost Decade, closed its doors. The vaunted Focus Fund is no more.

Here’s the second moral of the story: Past performance is no guarantee of future returns.

We say that, but I don’t think it sinks in with us. A fund will not necessarily do well in the future just because it did well in the past. Even the very best funds over a certain period can die over the next. There is no evidence for the persistence of performance.

When you select your investments, do not base it solely on a fund’s past performance. It may not mean squat.

Investment Selection by Potential Performance

Past performance is easy to look at it. But what about future performance? Is there any way to determine that? No, of course not. There is no way to tell if an investment will do well in the future.

That doesn’t stop the Financial Pornography Network or investment managers from trying. The former will whip out a thousand articles a day telling you what may be the next Amazon or Apple. The latter have grown quite adept at selling investment theories. But even when you find a Chief Investment Strategist keen on one fund or sector, you’ll find another with evidence for the opposite.

Most fund managers underperform their indexes over a given period. Most funds that over-perform one year go on to under-perform the year after. There is no way to know which one will be best in the future. Anyone who tells you otherwise is selling something.

Investment Selection by Star Rating

A popular way to select funds is based on their Star Rating. The rating company Morningstar produces a Star Rating for most funds available from 1- to 5-Stars. Many people will select their funds based on their Star Ratings.

Star Ratings are calculated based on risk-adjusted past performance. What does risk-adjusted mean?

Risk-Adjusted Returns Aren’t Everything

Generally, it’s the volatility a fund went through to achieve that return. An equity fund with a 10% rate of return may receive four stars, while a bond fund with a 4% rate of return may receive 5. Even though the equity fund had better performance, it had more volatility to get there. This makes sense to some extent, otherwise equity funds would mostly be 4 and 5 stars, and fixed-income funds would most be 1 to 3.

But this doesn’t tell the whole story. As discussed in Episodes 13, 52, and others, volatility is not a problem. It’s the price we pay for superior returns.

An S&P 500 fund may be five stars with a 10% rate of return. A small-cap fund may be three stars with a 12% rate of return over the same period. If you only select based on star ratings, you may be missing out on superior long-term performance in an attempt to reduce your volatility.

The Past has Different Lengths

Morningstar issues star ratings for funds that have been around for at least three years. It has a weighting system for the length of history, heavily weighting a fund’s 10-year return over its 3-year return. But there is a big difference between 3-year histories and 10-year histories.

A fund that is only three years old can be rated five stars. And a fund that is 10+ years old may only get 4. Is the 5-star fund better? Who knows!? It’s only been around for three years. It hasn’t had time to do poorly yet. You can’t compare funds of different lengths, even if Morningstar says you can.

Past Performance is No Guarantee

Perhaps you caught it when we first brought up how Star Ratings are calculated. They are applied based on risk-adjusted past performance. And what does that mean as far as future performance? Squat.

Just because a fund performed well in the past doesn’t mean it will in the future.

There is a concept called “regression to the mean.” It essentially states that when volatile numbers will return to their long-term average. Equities average 10% over decades. If a fund has recently outperformed that average, it will likely move into a period of underperformance to return to the long-term average.

People who move their money into five-star funds are buying funds that are just as likely to underperform going forward as they are to continue their great returns.

If you find yourself in five-star funds, that doesn’t mean you should get out of them. But you shouldn’t continue to move your money into five-star funds when you see that your current selection has lost a star or two. That’s called “chasing returns” and is the first of the Four Horsemen.

Don’t select your investments based on star ratings.

If we shouldn’t select them based on past performance, potential performance, or star rating, how should we choose them?

Investment Selection the Right Way

You have a goal and a plan to get there. You’re building a portfolio and have determined your asset allocation and diversification. You’re selecting lower fees when possible. What do you choose?

Two caveats.

First, this is not investment advice. I do that one-on-one with clients, not one-to-many via podcast.

Second, there are a thousand wrong ways to select investments and a few good ones. I subscribe to and teach one of the good ones. There are other strategies out there, and proponents of those strategies would agree that there are a few good strategies at the top. As long as you’re in one of those, six of one is worth a half dozen of the other.

I subscribe to index investing. We could do another podcast on Active vs. Passive investing. I don’t teach, as some passive advocates do, that you should put all your money in Vanguard’s Total Market Fund or a Target Date Fund. There are better strategies than a total market fund, and Target Date Funds are awful. No one should be in them.

The beauty of index investing is that they self-select for success. While a single company may die (remember Circuit City?), an index of them won’t. A dying company will simply fall out of the index. And while past performance won’t guarantee future returns in a fund (did someone say CGM’s Focus Fund?), past performance of the best businesses in the world appears to continue.

My portfolios are constructed of multiple index funds that follow indexes that have been around for decades. Not new indexes just created to follow some hot trend, but indexes that have been around for thirty years or more and have a track record of persistence. The long-term performance of all of these indexes is double digits.

Those indexes rise and fall, sometimes together and sometimes separately. The strategy creates opportunities to rebalance, selling a little bit high and buying a little bit low. The funds’ star ratings change as the performance ebbs and flows, but we don’t deviate. It allows us to capture a greater breadth of companies than just the S&P 500 or a Total Stock Market fund.

My personal investments are invested in the same way as my clients’. If there was a better way to invest for my children and legacy, I would do it. But there isn’t.

Again, I can’t tell you what funds those are. That’s too close to investment advice. And I’m not saying you should do this for the same reason. But a principled and disciplined approach to long-term investing is the only way to find long-term success. Your behavior and asset allocation matter more than investment selection by orders of magnitude.

This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are those of the people expressing them. Any performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be directly invested in.