Most people evaluate money managers from their past returns, but it is easy to get into trouble doing this. Here are some of the potential problems:
1. Future returns. If you and many other investors buy a mutual fund that has recently experienced exceptional returns, that fund will be flooded with cash. In a rising stock market that low-paying cash will drag down future investment returns.
2. Taxes. Furthermore, you will potentially be liable for taxes on past gains if your fund is not in a tax-sheltered retirement account. As your fund sells its holdings (and stock funds on average sell 80-95% of their investments each year), you become liable for your share of capital gains from those sales.
3. Transaction costs. Chasing returns can mean selling bad - usually defined as underperforming - investments and buying good ones. The buying and selling of investments is generally not free and those costs can lower overall return.
4. Timing issues. Selling "bad" investments and replacing them with different "good" ones can sometimes result in selling at low prices and buying at high ones - the exact opposite of what you want to achieve.
What, then, can and should you do? We can learn from the academic financial research:
1. You can't predict performance: managers with past higher returns on average do not repeat their outstanding performance.
2. Investments with extraordinary gains can also have extraordinary losses.
3. Buying and selling costs are important. Investment costs include management fees (for paying the managers), office/bookkeeping fees, promotional and selling fees, and transactions costs from buying and selling securities. These can be as low as 0.3% per year but can be as high 1.5 - 3+%/ year. In fact, because of these costs, actively managed stock mutual funds routinely underperform their benchmark. (WF Sharpe, Financial Analyst Journal, 47, 7 (1991); JL Davis, Financial Analyst Journal, 57, 19 (2001).)
What criteria should you use when you are selecting an investment? Look for high diversification and low turnover. This strategy is sometimes called a buy-and-hold approach. Instead of chasing returns, buy diversified, high-quality, low cost investments, and hold them, particularly if you do not need to cash them in anytime soon.