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Past Returns Are Not Indicative Of Future Results

Posted By Jim On 05/07/2008 @ 7:11 am In Investing | 2 Comments

Bear Stearns had 85 straight years of profits followed by one bad quarter and then a fire sale at $2.30 to JP Morgan Chase, which was increased to $10. (though the mid-2007 catastrophic failures of two big hedge funds, the High Grade Structured Credit Enhanced Leverage Fund and the High-Grade Structured Credit Fund, might have indicated things were a little shaky at Bear Stearns)

Bill Miller, chairman and CEO of Legg Mason Capital, beat the market for 15 years straight before “hitting a wall in 2006 [3].” Since then he’s bad some spectacularly unlucky moves by investing heavily in Countrywide, KB Homes, and Bear Stearns.

Roulette wheels show the history of the spins not because it’ll give players an edge in picking the next number, they do it to entice you to bet. Intellectually, people understand this. Emotionally, they throw caution to the wind if they see five red numbers hit in a row. They’re putting their smart money on black. (then it comes up red again!)

So, if we need to pick a mutual fund and we shouldn’t rely on the past, what should we rely on?

Fees

The one thing you can predict and control about a particular mutual fund is the amount in fees you’ll pay. When selecting a fund, be sure to remember to take a look at the fees involved because they directly impact your rate of return. A 1% annual fee is a 1% decrease off your returns, which can be significant over the court of 40 years. A $1,000 investment that gains 10% each year will be worth $6,727.50 after 20 years, the same fund with a return of 9% a year is worth only $5,604.41 – a 20% difference in value! (and that’s based on a tiny starting investment)

Diversification

How does the fund stack up with your other investments? You need proper diversification to reduce risk and improve returns, so make sure the fund fits properly into your portfolio. While you can’t control the performance of the funds that make up your portfolio, you can at least ensure that you aren’t over-extended in one particular area. While this means that you won’t be hitting any home runs, you’ll be getting more base hits than strike-outs (think Ichiro Suzuki and not Alfonso Soriano).

Returns & Standard Deviation

While past returns are not indicative of future results, that doesn’t mean you shouldn’t pay attention to it! The key, however, isn’t to focus entirely on the returns but to check out the standard deviation of those returns. That will give you an indication of how wide future swings may be and you might not want a fund that can just as easily return 30% as lose 30% (or you do!).

So, when reviewing funds, don’t look just at the returns because they don’t mean much. Look instead at the things you can control (fees and your own diversification).

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The 151st Carnival of Personal Finance [4] (amazing, one hundred and fifty one carnivals…) is available at Alpha Consumer, my post about laddering CD’s at ING Direct [5] was included this week.


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[2] Email: mailto:?subject=http://www.bargaineering.com/articles/past-returns-are-not-indicative-of-future-results.html

[3] hitting a wall in 2006: http://money.cnn.com/galleries/2008/fortune/0803/gallery.bear_big_losers.fortune/5.html

[4] 151st Carnival of Personal Finance: http://www.usnews.com/blogs/alpha-consumer/2008/5/5/bloggers-on-surviving-the-squeeze.html

[5] laddering CD’s at ING Direct: http://www.bargaineering.com/articles/laddering-cds-at-ing-direct.html

Thank you for reading!