Mutual fund trading can be risky—and will likely hurt your long-term returns.
While you don’t want to buy and hold mutual funds indefinitely, frequent mutual fund trading can be risky—and hurt your long-term returns.
Over the last number of decades, many mutual fund investors have lost sight of this risk. Mutual funds can make good long-term investments, but sometimes investors get caught up in mutual fund trading and the risky practice of momentum investing.
You might think of momentum investing as a mutation of growth-stock investing. Traditionally, growth-stock investors zero in on companies that have reported several years of growth and seem likely to keep on growing. Whether investing in mutual funds or stocks, growth investors tend to focus on investments that they plan to hold for months if not years.
When it comes to mutual fund trading, all too many amateur and professional investors and advisors try to take the easy way out. Instead of looking at the hard stuff—company fundamentals, industry trends, business plans and so on—they try to profit with a strategy called “momentum investing.”
Momentum investors focus on growth stocks and funds—but with a shorter-term focus. They want to hold these investments only while prices are rising. They don’t mind paying a high price, because they plan to sell quickly if the rise begins to falter.
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A momentum mutual fund trading approach will eventually cost you money.
Momentum investors are keen on the so-called “positive earnings surprise,” when a company outdoes brokers’ earnings estimates. They view a “negative earnings surprise”—lower-than-expected earnings—as a sell signal. They use a variety of formulas to make buy and sell decisions, but all come down to “buy on strength and sell on weakness.” So they tend to pile into the same stocks all at once, and the gains that follow are something of a self-fulfilling prophecy.
One key problem is that when the stock’s rise falters, momentum investors try to get out as a group, but there are never enough buyers. This leads to violent price fluctuations for these stocks, or mutual funds that hold them. When you hear that a stock reported a 10% earnings gain and its shares dropped 25% to 50%, it often means that the momentum investors who owned it were hoping for, say, a 12% earnings gain.
Momentum mutual fund trading is a risky approach to investing
It’s natural to be tempted by mutual fund trading schemes where you leapfrog from one fund to another, and routinely switching out of the laggards in your mutual fund portfolio and into funds with better performance. But basing investment decisions on performance alone is bound to cost you money sooner or later.
That’s because it raises your risk of investing in a fund that owes its performance to having gambled and won. When a gambler’s luck turns sour, he may give back all of his winnings and more besides.
Avoid this opposite but equally risky mistake
Some investors recognize the error of momentum mutual fund trading. They aim to profit by doing the reverse. When a fund they own goes up “too far and too fast,” as the saying goes, they sell and switch the money into a lagging fund, on the theory that funds alternate between leading and lagging. But that puts you at risk of selling your best funds way too early. It also puts you at risk of buying funds that own a lot of bad stocks. These funds may go much, much lower.
Regardless of whether you routinely sell laggards to buy leaders, or sell leaders to buy laggards, you are making the same mistake: you are still basing your investment decisions purely on investment pricing, and ignoring investment quality. That’s bound to hurt your results. There’s a big random element in investment pricing. In contrast, investment quality is the key to long-term safety and profit.
We continue to believe the best approach to long-term profit is to not get caught up in momentum mutual fund trading. Instead, stick to holding well-managed funds that seek value and investment quality in their investment choices.
Here are three tips to help you in your mutual fund buying—rather than mutual fund trading
1. Get out of buying “theme” mutual funds
If the mutual fund’s theme seems to be plucked from recent headlines, stay away. It pays to stay out of narrow-focus, faddish funds, all the more so if they’ve come to market when the fad dominates the financial headlines.
Theme funds like these face a double disadvantage, because they appeal to impulsive investors who pour their money in just as the fad hits its peak. This forces the manager to pay top prices— perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the mutual fund manager to sell at the bottom and lowering the mutual fund’s performance. But when a fad fades, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the mutual fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.
2. Beware of buying vaguely described mutual funds
Get rid of mutual funds that show wide disparities between the mutual fund’s portfolio and the investments that the sales literature describes. Many mutual fund operators describe their investing style in vague terms.
It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at a mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. When the mutual fund takes on a lot more risk than you’d expect, our advice is to get out.
3. Avoid buying mutual funds with anonymous managers
This includes buying mutual funds run by committees. The trouble here is that the brains of the mutual fund may leave, and investors would never know it until they saw the drop in their mutual fund’s performance.
Have you ever gotten caught up in mutual fund trading? Did you lose a lot of money? Maybe you only have nominal profits. Share your experience with us in the comments.
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