Question

I’m now eligible for my 401(k), and I need to pick which mutual funds to invest my contributions into. I’m not sure exactly how to do this, but I can see which ones had the best returns over the last one, three, and five years, so I just thought I’d put all my money into the top two or three of them so I’m diversified. Is that the right approach?

Answer

“Performance chasing” is widely recognized by behavioral economists as a serious investing error. In fact, it’s such a bad idea that mutual funds are required by law to include a statement in their paperwork saying something to the effect that past performance is no guarantee of future results. I wish the statement were even stronger, saying something like, “Outsized past performance is highly likely to reverse in the near future.” But, alas, investing is a caveat emptor activity.

Performance chasing is easy to do. It is often driven by FOMO—fear of missing out. We hear about our friends making money in ARK funds, meme stocks, Beanie Babies, or Bitcoin and pile in, only to suffer through the inevitable downturn inherent in popular investment booms. At that point, fear of loss usually kicks in and we sell low. “Buy high and sell low” is not a recipe for investment success.

The truth is that the outperformance of a few mutual funds in your 401(k) is far more likely due to what they invest in than the skill of their managers. For example, over the last five to 10 years, U.S. stocks have generally outperformed international stocks, bonds, and real estate, especially the large cap “growth” and “tech” stocks, like NVIDIA, Meta (Facebook), Amazon, and Alphabet (Google). So any mutual fund that was invested heavily in those stocks will demonstrate excellent results over the last few years, no matter what their investment strategy. Chances are, the top two or three funds in your 401(k) are all invested in those same types of stocks, and buying three funds that all invest in the same stocks is just false diversification.

The data are very clear that the outperformance of active mutual fund managers does not persist. Well, it may, but only among the worst ones. Some studies show that the top quintile of managers for a given year are no more likely to be in the top quintile the next year than any other manager, but the bottom quintile managers are actually more likely to be in the bottom quintile the next year. Sometimes their funds simply close and disappear from the historical record. A more recent study by the mutual fund gurus at Morningstar concluded:

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.

If you need help doing so, consider hiring a fiduciary, fee-only financial planner who provides good advice at a fair price. While this stuff is not that hard to learn, the consequences of doing it poorly (or not doing it at all) compound over time. It may be well worth paying a few thousand dollars to get started on the right foot. Alternatively, come to the ACEP-sponsored workshop the Saturday prior to ACEP24 in Las Vegas, and I’ll help you walk through the process of writing your own financial plan.

Whatever you do, don’t just buy the hottest performing stock, mutual fund, or other investment available—that approach does not necessarily lead to long-term investing success.

Dr. Dahle blogs at https://www.whitecoatinvestor.com and is a best-selling author and podcaster. He is not a licensed financial adviser, accountant, or attorney and recommends you consult with your own advisers prior to acting on any information you read here.