People are more persistent than mutual funds

Tell me if you’ve ever come across this statement before:

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

This is, I’m sure you’ll agree, the standard disclaimer found on mutual fund prospectuses and advertisements across the country. Everyone knows it. Everyone has seen it.

My question is…Why do so many people act as if it isn’t true? If past performance cannot be relied upon for decision-making, why do so many people use that as their primary determinative consideration when choosing mutual funds?

If the disclaimer said…Reading tea leaves cannot be relied upon for making investment decisions…would you go to a client saying…Here are the products we have chosen for you based on our proprietary reading of your tea leaves?

If it said…Reading chicken entrails is not a reliable way to go about making investment decisions…would you come to a client saying…This is the portfolio we have constructed for you by virtue of our proprietary, state-of-the-art reader of chicken entrails?

If your answers are “No” then why would you even consider making recommendations based on past performance? Here’s a simple exercise in logic. Let’s not use past performance or entrails or tea leaves. Let’s just call the thing in question ‘Process X’. Here’s the abbreviated statement:

This product is not guaranteed, its value changes frequently and reliance on Process X is not advised for decision-making. The point here is not whether Process X involves tea leaves, past performance or chicken entrails. No matter what the actual process is, it is unreliable… so for goodness sake, stop relying on it!

At issue here is the notion of persistence. Ever since Mark Carhart’s groundbreaking study on the subject more than a generation ago, it has been widely recognized that the performance of mutual funds does not persist in any kind of a reliable fashion – except that expensive, underperforming funds tend to continue to do so.

Ironically, even as past performance is a lousy predictor of future performance, current costs are an excellent predictor of future costs (translation: costs persist). There’s also a well-established correlation between cost and performance. Please refer to just about anything written by John Bogle if you doubt me.

In offering advice to clients, I believe people should do what management thinker Rosemary Stewart suggests – focus on our sphere of influence rather than our sphere of concern. To whit: we may be concerned about performance, but we can’t reliably control it. Meanwhile, we can control product costs (or at least select products based on costs that are highly likely to persist).

Management of anything (including your clients’ portfolios) depends on how you work with the things you can control. If you can’t control something, you can’t manage it – and no one can control mutual fund performance going forward. As such, I wonder why so many advisors persist in their product recommendations that are based primarily on past performance.

John De Goey, CFP, is the vice president of Burgeonvest Bick Securities Limited (BBSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BBSL. You can learn more about John at his Web site: www.johndegoey.com.