The momentum approach rarely works for investors looking for successful mutual fund investing opportunities
Interested in mutual fund investing? Read on to learn what to avoid while investing in mutual funds, including above all, the momentum approach.
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A momentum approach will eventually cost you money while mutual fund investing
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 and ETFs 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.
Avoid mutual funds investing where managers pride themselves on trading heavily
Some of the most dangerous funds are those run by managers who honestly believe they can increase their performance by frequent in-and-out trading. Many of these managers fail to realize how close their mutual fund’s performance comes to disaster each year, until disaster finally strikes.
If you add up a heavy trader’s losses at the end of a given year, they may amount to a high percentage of their fund’s assets (25%, for example). That may seem perfectly acceptable to the mutual fund manager, so long as the profits on their winning trades are significantly higher than that (for example, 75% of assets).
If the mutual fund manager guesses wrong a few times, however, it’s all too easy to reverse those figures: that is, have losses totalling 75% of assets and profits totalling 25%, so that the mutual fund loses 50% of its capital. If the manager delves into low-quality or highly volatile choices, as heavy traders are apt to do, then the mutual fund’s performance can drop.
“Mutual fund leapfrog” is a risky approach to mutual fund investing
It’s natural to be tempted to try a momentum investing approach by leapfrogging 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.
Bonus mutual fund investing tip: 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.
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