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One Of My 10 Biggest Financial Mistakes

03/10/09 10:36:10 AM PST
by Brad Burch, PhD

I did not systematically invest in mutual funds.

A math doodler all my life, I began to wonder about investing a set amount in specific intervals and how it would add up over 15 to 20 years. The autumn of 1990 saw my retirement fund increase by 50%. I had invested the money right before the first Gulf War. At that time, many mutual funds initially went down but then were sparked by a great rebound in the market. I remember sharing this observation with a colleague who said, "Wow! Let me just touch your statement!" I was so excited by this outcome it inspired me to do charts like the one displayed in Figure 1, which shows money consistently invested each month into an account that appreciates 12% each year. (This makes the math easy: multiplying the previous month's total by $0.01 adds up to 12% in 12 months.)

FIGURE 1: CONSISTENTLY INVESTING EACH MONTH INTO AN ACCOUNT THAT APPRECIATES 12% EACH YEAR. Investing $16,000 in March 1991 and investing $100 each month in mutual funds that return, on average, 12% per year would result in $261,508 at the end of 2009.

If I had taken my $16,000 in March 1991 and methodically invested $100 in the best-performing mutual funds each month with an annual rate of 12%, the amount of my portfolio would be $261,508 at the end of 2009. (Sure, 2008 was horrible, as were other years within the mix -- but there would probably have been some returns better than 12%.) Sure, I may have missed months, the funds may have dropped quicker than I moved my monies, or the returns might not have happened or the monthly returns may have been higher. And 12% is an arbitrary rate of return and may be unrealistically high.

FIGURE 2: CONSISTENTLY INVESTING EACH MONTH INTO AN ACCOUNT THAT APPRECIATES 6% EACH YEAR. Investing $16,000 in March 1991 and investing $100 each month in mutual funds that return, on average, 6% each year would result in $101,104 at the end of 2009.

Consider the same chart at an annual return of 6% (Figure 2). Again, this keeps the math simple: multiplying the previous month's total by $0.005 to add up to 6% in 12 months. If I had taken my $16,000 in March 1991 and methodically invested $100 in the best-performing mutual funds each month with an annual rate of 6%, the amount of my portfolio would have been $101,104 at the end of 2009. But I didn't invest methodically each month.

Step 1: Understanding the charts is a first step, but the challenge is to consistently and methodically find the funds that deliver the best returns. I keep reading statements that warn that past performance is no guarantee of future returns. While that is true, past performance may be one indicator of a fund's near-term future success.

In 1991, I studied the returns of mutual funds for the past five years (I also conducted this study looking at the results of funds from 2001 to 2006 and the results were the same). Almost immediately, I discounted loaded funds. Why? A loaded fund is where a percentage (usually 4% to 5%) is removed from the buy (front) or the sale (rear). Anyone who invests in a loaded fund is behind from the start. I also learned about 12b-1 fees, which are added to some funds on a sale. And then there are funds that get a transaction fee if the fund is not held long enough. What is it with funds and all the fees? It would be a lot simpler if the fees were only in one place or if there were only one price or (more). That's the way I feel about cell phones, too -- why all the fees?

Step 2: I began to look at no-load funds and the returns. I looked at several publications and picked NoLoad FundX, mainly because they claimed that past performance was an indicator of future performance. (Plus, several hundred no-load funds with various risk factors are followed.) I liked the idea of how math could be applied to each fund's return. The publishers of NoLoad FundX have a complicated formula that they claim will work over the long term, and it may, but I wanted something simpler. I studied the fund returns for one month, three months, six months, and one year.

For example, if I were searching for the best-performing funds in the previous month when January comes around, I would look for the best-performing fund in about 60-plus funds in each risk area. I would keep the money invested in my chosen fund until it stopped being one of the top 10 one-month gainers.

The February chart might state the fund I invested in is not among the best one-month performers in that month. This method of searching for the best one-month performers was the most volatile of the fund investment strategies. I also found that in a market going up, this method of looking for the best-performing one-month funds could dramatically increase a portfolio value if I invested during the beginning spurt of a fund -- or dramatically decrease a portfolio if the fund suddenly had a double-digit drop.

Step 3: Next, I looked for the best-performing three-month funds, six-month and one-year returns. The three-month return method was never consistent enough for me to find a winner over several months. I was constantly changing out of and into funds, and the returns did not justify the continual change in investments. The pattern for the six-month change was much less volatile and allowed me to stay with a fund through minor fluctuations. And remaining with that fund yielded the highest returns.

Step 4: The 12-month investment strategy also seemed to work well in terms of finding winners that would continue to perform well and keep mutual fund switching to a minimum. This strategy proved to be the least volatile, though the returns were not as great as staying with the winning six-month funds.

Staying in the highest-performing mutual funds can be risky, but it seems to make the most sense to me from simple addition and subtraction. The key is finding an investment strategy that I feel comfortable with and then sticking with it. How much volatility am I willing to live with? Am I comfortable always switching into the funds that grew the most over the last month, even though this strategy fluctuates the most? How long do I have until retirement? If I only have five years to retirement, do I want to invest using the most volatile strategy?

Staying with the winners should be a systematic investing methodology that involves buying high-ranking funds and holding them as long as they continue to outperform their peers. When some funds perform lower than others, the investor sells them and moves on to the new current winners. This can be tricky. Suppose your strategy involves looking at 100 mutual funds and trying to stay within the top 10 funds.

The first month, you invest in the top-performing fund. The next month, you see your fund has slipped to #3; the following month, it slips to #8; the third month, it moves to #4; the fourth month, to #9; the fifth month, to #11. Your study tells you to shift your investment to the top-performing fund in the list, but you have grown to like this fund and besides, maybe it will move back to the top 10 next month. The fund has done well for you. Why not just stay with the one fund?

It is unwise at this point to stick with this fund because it will not recover enough to outperform other funds that will do well. Admittedly, emotions play a part in any investment strategy when moving funds around. You know from your study of historical data that it is time to invest in a different fund.

If you are not sure, then go back and look again at the fund performances for the past several years, looking at funds as they move back and forth through the top-performing 15 funds. Your review may show that the funds are fine in the top 15; if so, stay invested in your fund until it falls out of the top 15.

But there comes a time to move to a better-performing fund if we are following an investment strategy. So do you stay with one fund (perhaps one that has had the best performance over the past five or 10 years) and have no investment strategy beyond that one fund, or do you stay with the winners? My experience tells me to move the funds and stay with the best-performing ones for as long as the fund remains in the top 10 six-month performing funds.

Again, the choice is yours. Do the historical research; see what works best for you. It depends on how much risk and volatility you are willing to assume.

This may be a grow-and-learn strategy for you. After looking at historical returns, you may decide to follow the strategy of investing in each month's largest-returning fund. You feel fine with this strategy until one month, the fund you are invested in drops 15% and you realize you are doing this with real money -- your retirement fund. This is your future and you have a family who is depending on you to invest in the proper fund. That can be a lot of pressure. You have to decide which strategy is best for you in terms of return and how much risk you are willing to assume.

Then there are socially responsible funds. And my conscience stopped me from following a consistent plan. At least that's what I tell myself. I want to believe that socially conscientious funds are a better investment option than other forms of mutual funds because they make the world a better place. I am not investing in companies that operate in countries that practice slavery. I am not investing in countries that oppress their people, or those of others. I am searching for companies and institutions whose products, services, and practices contribute to a more socially just society, as Social Investment Forum ( states. I am searching for companies that make this world a better place to live. But is that true? Or did I just get lazy and stop following a plan?

I like to think that by my investing in these companies that pronounce themselves ethical, I am making ethical decisions. But this strategy is tricky. Finding funds that practice certain ethical practices may mean that they are remiss in other practices. What am I concerned about? For me it is the environment. How can I invest in companies that continue to pollute the world in which I live? Is it enough for me, someone who believes that environmental protection is the most important issue of my time, to invest in companies that practice other ethical issues but do not care about the environment?

These are questions we all struggle with as we seek investment choices. There do not seem to be clear social choices that are always right or always wrong. Do we only invest in the winners from the previous one-, three-, six-, or 12-month period? Do we look at the investment objectives of the companies supported by these mutual funds?

I can't answer these questions for you. We must answer them ourselves as we become informed investors. My priority is to find successful funds that are also ethically concerned with the world we live in. I have several options. I can go find the top six-month performers, stay with them, and probably average at least 10% annual growth. Or should I invest in the top six-month socially responsible funds or just invest in a fund that has done well for the last 10 years and therefore has a proven track record through several market ups and downs? Or should I scrap it all and go with what a broker recommends? I am not in favor of this last strategy.

While I want to vote with my heart and impulsively charge out to save the world by investing in socially responsible funds, I'm not convinced that the managers of those funds are any more fiscally or socially wise. Should I only choose socially responsible mutual funds that focus on the environment and therefore lessen my choices that much more? Or is there something I'm missing?

How much should I ignore the money that can be made through investing in a solid, proven plan and build a significant nest egg for my wife and me? I think I will take advantage of these plans and choose socially responsible funds when they are performing well -- and keep my family's funds invested in the best-performing funds.

Brad Burch, PhD

Brad Burch lives in Greensboro, NC, with his wife, three children, a very happy beagle, and an indoor cat that yearns to escape. His career path has been varied: swim coach, dorm director, youth minister, university academic advisor. He currently serves as the registrar for Guilford Technical Community College.

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