What investors should understand when picking mutual funds

Correcting a few misconceptions will tell people how to make good investments

What investors should understand when picking mutual funds

When deciding on investments, people first need to be presented with the facts. But even after they are presented with accurate information, they may still make poor or incorrect choices based on misconceptions and biases.

For most investors, those misconceptions involve mutual funds. In a recent piece in the Wall Street Journal, Dr. Meir Statman, Glenn Klimek professor of finance at Santa Clara University, discussed problems of comprehension that could prevent people from investing in mutual funds wisely.

Find out everything about how to invest in Canadian mutual funds: what they are, the pros and cons.

He started with the established fact that, on average, active mutual-fund managers beat the market before costs, but the returns they provide net of costs lag those from low-cost index funds. So amateur investors might think that funds managed by professionals who beat the market are preferable, but they should consider costs and the difficulty of choosing a fund that can consistently beat the market.

Investors can also assess probabilities incorrectly based on easily-remembered information. As an example, Statman suggested that the average investor will assume a company that advertises four five-star funds, as rated by Morningstar, are more likely to have “winning” funds. However, they might fail to consider that only seven of the company’s 139 funds fall in that category — that is, only 5% have five-star ratings — while Morningstar gives that score to the top 10% of funds.

People also tend to overlook “base-rate” information in favour of “representative” information. As an example, Statman described a portfolio manager with a mathematics degree and an MBA from Harvard and Columbia University, respectively, who runs a mutual fund that’s beaten the S&P 500 index for 10 years running.

He pointed out that one of 1,024 people tossing a coin is likely to get 10 heads in a row, and there are easily more than 1,024 mutual funds in the market. That base-rate information, he suggested, shows that a 10-year market-beating streak isn’t spectacular. But people overlook that information, instead focusing on the manager’s credentials as being representative of an excellent manager and, by extension, an excellent fund.

“In other words, just because Jane has done well for 10 years in a row, just because she has two Ivy League degrees, doesn’t mean she will naturally continue to beat an index fund,” he said.

Finally, Statman noted that just because a mutual fund delivers lower returns doesn’t mean it’s less preferable. He pointed out that an investment’s ability to produce money may not be the same as its usefulness in satisfying wants. He discussed responsible investing as an example:

“For some people, it makes sense to invest in a conventional fund, get the highest returns, and donate one percentage point of those returns to support environmental causes, being true to your values. But for some people, it makes sense to invest in an environmental fund that earns one percentage point less than conventional funds but is true to your values.”

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