Investment funds offer investors a valuable option in growing and managing their wealth, especially in the area of retirement planning. There are disadvantages as well, most apparent in the obvious difficulty that arises in attempting to predict the future success of such funds. According to financial expert Robert Rosenkranz, caution is the best course for amateurs and experts alike when seeking to prognosticate fund success.
The U.S. Securities and Exchange Commission, or SEC, strictly governs the language used when discussing mutual funds. Touting past gains as a measure of future performance is simply not allowed under current rules. Random sampling proves why this is true: statistically speaking, it is possible for random choice to correctly pick successful stocks in a small number of cases, even for winning streaks lasting years at a time. This would be a false positive, however; it is a lucky break rather than actual skill in predicting the success of future trends.
The savvy investor must be able to distinguish between fund managers who have such lucky breaks and those with actual experience predicting success that is grounded in actual skill. Everyone is capable of having a good year based simply on blind luck. Access to the financial records of a manager will have to be the determining factor in deciding whether he or she is simply having a good year. Generally speaking, a manager who is consistently right about small stocks with a range of themes winning over time is exhibiting actual skill rather than blind luck. Success with a two-pronged approach including something like small cap stocks and technology is another good indicator, although these can also have one or two good years based on blind luck alone.
Size is another good indicator. A manager who could move the market in a significant way single-handedly in the past given current size versus one whose outcome would be illiquid is another indicator of caution. The psychology of the market is another factor. Junk bonds can sometimes offer a very high rate of return if the market’s psychology plays in their favor, but the risk is defaulting. Strong corporations rarely default, and because of this, offer a far lower rate of return. Diversifying a portfolio will act as a bulwark against the volatility of such junk bonds in the event they default.
When extended periods of good fortune leave the bond market looking stable, the default caused by a credit or economic collapse can result in companies unable to manage their debts. Looking at this track record can actually cause trouble for the prognosticating investor, as it is not a clear indication of a person’s skill in predicting the market and such events can actually be quite profitable for investors. In such situations, track record counts as nothing and is akin to trying to look backwards while attempting to walk forwards. Thus, the informed investor must consider not only a track record indicating success, but also be prepared to ignore that record based on current trends.