Proof That Past Performance Really Doesn't Predict Future Results

ASX Board in Melbourne shot July 2002 Australia
"You're riding high in April, shot down in May." Frank Sinatra made that lyric famous in his hit song "That's Life" nearly 50 years ago. It applies to life and to investing your money with the so-called smartest guys on Wall Street.

New research shows that strong performance by mutual fund managers is very hard to repeat year after year. In fact, S&P Dow Jones Indices finds that very few actively managed funds are able to consistently outperform their peers over even relatively short periods.

Most investors don't bother to wade through the fine print of the mutual fund prospectus. But if you did, you'd find they all caution that "past performance does not predict future returns," or something similar. And there's a reason the Securities and Exchange Commission requires that caveat: it's true.

Mutual fund rankings are often done by quartile -- the top 25 percent and the second 25 percent are better than average. The third 25 percent and -- god forbid -- the fourth are below average.

Its Not Easy Staying at the Top

S&P reports that a shockingly low number of funds stayed in the top performer group over a relatively short period of two years. It says that out of the 687 funds in the top quartile as of March of 2012, only 3.8 percent were still there two years later. And over five years, less than 1 percent of all domestic funds stayed in the top group.

"This just points out that in general, active managers cannot outperform" the herd, said Keith Loggie, director of global research at S&P Dow Jones Indices. "What happens one year does not indicate at all what will happen the following year."

"The odds of outperforming are essentially the same for everyone." - Keith Loggie

Loggie said the correlation between how a fund manager performs from one year to the next is even lower than flipping a coin would indicate. "You'd expect to have some outperformance, some star performers, over the longer term," according to Loggie, but that's rarely the case.

Of course, there are notable exceptions. Peter Lynch ran Fidelity's (FNF) Magellan Fund (FMGKX) from 1977 to 1990, returning an astounding 29 percent per year. And Bill Miller outperformed the S&P 500 index (^GPSC) from 1991 through 2005 as manager of the Legg Mason (LM) Capital Management Value Trust (LMVTX).

"While there will be Millers and Lynchs out there," said Loggie, "it's very hard for investors to identify that beforehand. The odds of outperforming are essentially the same for everyone."

Merged or Liquidated

What's just as remarkable as the lack of consistency is the likelihood that top-performing funds will drop into the bottom-performing group. The S&P report finds that more than 28 percent of the top-performing funds will fall to the lowest quartile, while 28 percent of the bottom feeders will rise to the top.

And what happens to funds that consistently underperform? About four in ten of the funds in the bottom quartile over a five-year period are merged into better-performing funds or are liquidated.

What can consumers do to avoid some of those gyrations? Many independent money managers suggest index funds that track market indexes, such as the S&P 500 or the Russell 2000 (^RUT).

"Retail investors think they need to find the one, two, three funds that will outperform," said Marck Salzinger, publisher of The No-Load Fund Investor newsletter. "They need to reverse that and avoid funds that will underperform."

Since it's nearly impossible for the stock market pros to consistently outperform, what chance do we have as individual investors? Apparently, not much. And if that's the case, Salzinger says "keep it simple. Complicated is not more profitable than simple."

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Invest and deposit with great care, not only to protect your time, your hard work, but to avoid feeding a monster!

July 13 2014 at 11:58 AM Report abuse +1 rate up rate down Reply

Invest; To lend at great risk of loss for very little return!

July 13 2014 at 11:55 AM Report abuse +1 rate up rate down Reply

Recommended reading - The Book of Common Sense Investing by John Bogle. The immutable truth of mathematics shows that trying to beat the market is a loser's game. Be satisfied with your fair share of the overall market growth over time. The solution is buying and keeping no load, low cost, broad spectrum index funds through long term dollar cost averaging investment.

July 13 2014 at 11:23 AM Report abuse +1 rate up rate down Reply

Buy high quality companies that increase the dividend paid each year to their stockholders. And, don't trade them. In other words....invest

July 12 2014 at 5:25 PM Report abuse +1 rate up rate down Reply
1 reply to mrwarmth51's comment

Yes, you are so right.

July 12 2014 at 6:16 PM Report abuse +1 rate up rate down Reply

Best way to quadruple your money is to take a hundred dollar bill out of your wallet. Fold it in two, then fold it in two again, and put it back into your wallet.

July 12 2014 at 6:35 AM Report abuse -2 rate up rate down Reply
1 reply to alfredschrader's comment

That will make you a lot of money, NOT

July 12 2014 at 6:15 PM Report abuse +2 rate up rate down Reply

Never buy a mutual fund... That is like paying someone to sit and watch the grass grow in your yard. Buy your own stocks. If you like a mutual fund, then look up the stocks it holds and duplicate the same in your personal portfolio. There is no reason to pay a bank or a mutual fund manager to buy stocks that you can get with an online broker like TDAmeritrade, Scottrade, Schwab, or Etrade.. Mutual funds are for hicks that have no idea how money works.

July 12 2014 at 4:25 AM Report abuse +1 rate up rate down Reply
1 reply to socioeconomist1's comment

some of us know, but are too lazy to do it ourselves.

July 12 2014 at 3:25 PM Report abuse -1 rate up rate down Reply

The problem with my money in my pocket, it doesn't grow. I get 1% on my savings, and with wages not keeping up with inflation or our CEO's wages, what's a person to do? We keep falling behind. The annual 1% increase in pay is a joke, and still expected top work a 50 hour week. Bring back the unions.

July 11 2014 at 2:28 PM Report abuse -1 rate up rate down Reply

This article should be read, re-read, and memorized by anyone who puts their hard-earned money in the market. Forget about picking stocks. Forget about picking stock funds. Just buy a Dow index fund, an S&P index fund, and if you're feeling adventurous, a NASDQ index fund. Then never sell until you absolutely have to, which should be when you are nearing retirement. Buy ETF's like DIA or SPY, or the Q's. Fund managers are no better at their job that the guys that tout the next good thing at Belmont in the 9th. Keep your money where it belongs--in YOUR pocket.

July 11 2014 at 12:44 PM Report abuse -2 rate up rate down Reply
1 reply to bolmsted114's comment

Nah. I pass

I'm shorting all of them

July 11 2014 at 11:36 PM Report abuse -2 rate up rate down Reply