ARTICLE:
Chasing After Winners Can Turn Your Portfolio Into A Loser

Daily newspapers and financial magazines will soon begin the ritual of listing the top-performing mutual funds of 2005. Your first impulse may be to plow your money into the names at the top. Don't. "Past performance is no guarantee of future results." I know you've heard it a million times before but despite this phrase's presence in practically every mutual fund ad ever created, not enough investors pay attention to it.

According to a report by the investment company institute, 88% of fund buyers cite past performance as the primary reason they select one fund over another. And really, it's hard to blame them. It seems perfectly reasonable to think that if a fund posted an above average return in one year, it's got a pretty good shot of doing it again next year too. However, just because a fund produced a year of above average performance does not mean that one should expect above average performance the following year.

Imagine a coin-flipping contest with 1,000 people. The contest begins, and they all flip coins. Just as would be expected by chance, 500 of them flip heads, and these winners advance to the second stage of the contest and flip again. As might be expected, 250 flip heads. Operating under the laws of chance, there will be 125 winners in the third round, 62 in the 4th, 31 in the 5th, 16 in the 6th, and 8 in the 7th round. By this time, crowds start to gather to witness the surprising ability of these expert coin flippers. The winners are overwhelmed with adulation. They are celebrated as geniuses in the art of coin flipping -- their biographies are written, and people urgently seek their advice. After all, there were 1,000 contestants, and only eight could consistently flip heads. What If this contest were held again the following year, what do you think the chances are of the same 8 people winning again? As in flipping coins, the same could be said for mutual funds.

The single factor that best explains why some funds end up on the top performing lists and some don't is not the result of superior fund management, but rather the result of a hot sector, or asset class (e.g. large or small cap stocks, value of growth). Almost any fund devoted to a recent hot sector is going to do well, regardless of the talents of its fund manager. Conversely, even the most brilliant fund manager cannot hope to be among the "hot funds" list if he or she is managing a large growth fund when small value stocks are in favor. Yet, most investors choose their mutual funds based solely on past performance.

The following chart demonstrates how the top 10 performing mutual funds from 1999 through 2003 performed the following years. The funds are not identified because the purpose of this illustration is not to promote a particular fund, but rather to emphasize that choosing mutual funds based solely on past performance is a recipe for financial disaster.

	1999	2000	2000	2001	2001	2002	2002	2003	2003	2004
	1	4,161	1	3,056	1	35	1	1,067	1	5,989
	2	4,267	2	1,255	2	945	2	509	2	6,045
	3	4,510	3	999	3	4,515	3	714	3	139
	4	4,059	4	3,568	4	2,849	4	467	4	5,954
	5	4,485	5	1,244	5	3,384	5	20	5	1,009
	6	4,495	6	3,011	6	3,126	6	826	6	70
	7	4,511	7	3,423	7	1,392	7	106	7	5,450
	8	3,458	8	764	8	1,741	8	587	8	223
	9	4,498	9	3,588	9	1,579	9	127	9	2,893
	10	4,578	10	2,636	10	2,874	10	78	10	1,467
Total # Funds	4,237	4,578	4,578	5,091	5,091	5,432	5,432	5,476	5,476	6,046

Source: Morningstar Principia

We can examine the top 10 funds for the last year, five years, or even ten years, and the results would be the same - the winners don't repeat. In fact academic studies have shown that over the last four decades, of the top 50 performing mutual funds in a given year, 44 of those funds, (88%) drop out of the top 50 best fund list the following year. if past performance had predictive value, then Forbes' Honor Roll would list the same group of funds every year. Investors should be asking themselves: Why don't the same funds repeat their appearance on the Best Buy lists of Smart Money, and Kiplinger's as well? If the same funds don't repeat, just how valuable are these lists?

Investors need to stop listening to the relentless pitches of Wall Street, financial magazines, and advisers who rely solely on past returns. After all, this is retirement money we're talking about here. When it comes to investing, it is essential that investors understand the importance of Asset Allocation. Asset Allocation is based on "Modern Portfolio Theory." In 1952, Harry Markowitz, regarded as the "father of modern portfolio theory," developed the first mathematical model that illustrated how risk can be reduced through diversification of investments that have different patterns of return. This concept had such a profound impact on the study of economics and investment management, that he was awarded a Nobel Prize for Economics in 1990. With such credibility and historical track record, why is it that investors have such a difficult time implementing this strategy?

The most prevalent problem with asset allocation is that investors don't realize the basic principle of this model. As stated earlier, many individuals have been conditioned to look at the performance of their investments on an individual basis, while the basis of asset allocation focuses on the performance of the overall portfolio. A properly allocated portfolio is composed of assets with dissimilar behaviors, (i.e. value and growth, small and large, domestic and international funds) so that the upward movement of one asset potentially offsets the downward movement of another. In the short run, there will always be an asset class in first place that is delivering better performance than the other parts of the portfolio. However over the long-term, the rotation of leadership from one asset class to another act's to improve the risk-adjusted performance of the portfolio as a whole. It is this dissimilarity in patterns of returns of the various asset classes that are likely to maximize your chances of investment success while keeping your risk under control.

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