Over the long term, there is no meaningful relationship between past and future fund performance. In most cases, the odds of picking a future long-term winner from the best-performing quintile in each category aren’t materially different than selecting from the bottom quintile. The results strongly indicate that long-term investors should not select funds based on past performance alone.
As a rule, the more you pay for an investment, the worse its future returns will be. If you can buy a rental property with a net income of $20,000 for $200,000, that will probably be a great investment. Not so much if you pay $600,000 for that same property. That’s exactly what is happening when you buy any other investment after a recent run-up in price. You’re paying more for every dollar of earnings it generates, and thus your return must be lower than that of an investor who bought it at a lower price.
Any student of the markets will quickly see that there is a pendulum effect as different types of investments come in and out of favor. Sometimes growth stocks do well. Sometimes value stocks do well. Sometimes small stocks or Chinese stocks or utility stocks do well. Sometimes bonds or real estate perform well. Predicting which will do best in the near future is extraordinarily difficult. In my opinion, it’s so difficult that it is probably not worth trying to do so. Certainly, there is no evidence that just buying whatever did best in the last year, three years, or even five years is going to lead to investment success. But doing the opposite isn’t any more successful; you can’t just take a contrarian approach and buy whatever did most poorly last year, either. Sometimes stocks have gone down in value for a reason—because the company is en route to bankruptcy. Perhaps if it recovers, you will make out like a bandit by buying low. The company behind the stock often does not rebound; good or bad performance may persist longer than expected.
So what should an investor do if they can’t just pick the best performing funds out of their 401(k)? How about creating a reasonable, written investment plan instead? Determine a priori how much of the portfolio will be invested into U.S. stocks, international stocks, bonds, real estate, and other investments. Then look “under the hood” at what the available funds in your 401(k) actually invest in and choose them based on the underlying investments. Among funds that invest in similar investments, the best predictor of future performance is low costs, so choose the one with the lowest expenses. These will usually be index funds.
