What the Kentucky Derby can teach us about picking mutual funds
(and why performance chasing is one of the most expensive habits in investing)
The 150,000-person stadium falls silent. Twenty of the world’s fastest horses snort and stomp in anticipation. The starting shot is fired, the gates swing open, and the horses explode out of their stalls at nearly 35 miles an hour. As the horses sprint around the track, millions fill out brackets, consulting past-performance charts, and placed bets on the horse that looks most likely to win. And almost every year, a disproportionate share of that betting volume goes to one horse in particular: whichever one won the most recent big race.
It feels rational. Past winners should keep winning, right?
Investors do almost the same thing with their retirement savings. They look at a list of fund options, find whichever one delivered the highest return last year, and move their money there. It feels smart. It is, unfortunately, a habit that quietly costs investors real money.
The past doesn’t always predict the future.
Just because a fund had a 30% rate of return last year does not mean that you’ll see a similar result this year. In fact, of all the actively managed U.S. equity funds that finished in the top quartile of their category in a given year, fewer than 25% finished in the top quartile the next year. If you extrapolate this out to just 5 years, the chance that the high-performing fund is even in the top quartile anymore is near zero. So just because a fund did well last year doesn’t mean it will do as well in the upcoming years.
Why don’t the winners keep winning?
As anyone who’s been watching their investments can attest, the markets have been very volatile these last few years, and this volatility rewards different types of companies at different times. And by the time an investor has noticed a valuable asset, it may have already peaked. Think of all of the COVID-era investments that surged in 2021 but have now crashed, like Peloton or Zoom. It’s not that these aren’t good companies; it’s that the markets decided to reward different types of investments. As the landscape of the market changes, so does the landscape of investments that thrive within it.
How to “Win” the Retirement Derby
If choosing last year’s champion is a losing strategy, what are some winning ones?
Rebalance – This allows you to trim from the assets that have done well and add to the assets that may do well soon. If your plan offers automatic rebalancing, select it!
Stay Invested – Missing the ten best days in the market over the past 20 years would have cut your returns in half. And those ten best days overwhelmingly happen near the ten worst days, when investors are most tempted to flee.
Diversify – If you don’t know which category of the market will lead this year, own a little of each. This is what target-date funds and balanced portfolios are designed to do automatically.
The Kentucky Derby is two minutes of chaos and luck. Your retirement plan is 30 or 40 years of patience and discipline. You don’t need to pick the fastest horse, you just need to stay in the race. If you’d like help building a portfolio that’s built for the long run, our team is always here. We’re much better at retirement planning than picking ponies.