Question

I’m now eligible for my 401(k), and I need to pick which mutual funds to invest my contributions into. I’m not sure exactly how to do this, but I can see which ones had the best returns over the last one, three, and five years, so I just thought I’d put all my money into the top two or three of them so I’m diversified. Is that the right approach?

Answer

“Performance chasing” is widely recognized by behavioral economists as a serious investing error. In fact, it’s such a bad idea that mutual funds are required by law to include a statement in their paperwork saying something to the effect that past performance is no guarantee of future results. I wish the statement were even stronger, saying something like, “Outsized past performance is highly likely to reverse in the near future.” But, alas, investing is a caveat emptor activity.

Performance chasing is easy to do. It is often driven by FOMO—fear of missing out. We hear about our friends making money in ARK funds, meme stocks, Beanie Babies, or Bitcoin and pile in, only to suffer through the inevitable downturn inherent in popular investment booms. At that point, fear of loss usually kicks in and we sell low. “Buy high and sell low” is not a recipe for investment success.

The truth is that the outperformance of a few mutual funds in your 401(k) is far more likely due to what they invest in than the skill of their managers. For example, over the last five to 10 years, U.S. stocks have generally outperformed international stocks, bonds, and real estate, especially the large cap “growth” and “tech” stocks, like NVIDIA, Meta (Facebook), Amazon, and Alphabet (Google). So any mutual fund that was invested heavily in those stocks will demonstrate excellent results over the last few years, no matter what their investment strategy. Chances are, the top two or three funds in your 401(k) are all invested in those same types of stocks, and buying three funds that all invest in the same stocks is just false diversification.

The data are very clear that the outperformance of active mutual fund managers does not persist. Well, it may, but only among the worst ones. Some studies show that the top quintile of managers for a given year are no more likely to be in the top quintile the next year than any other manager, but the bottom quintile managers are actually more likely to be in the bottom quintile the next year. Sometimes their funds simply close and disappear from the historical record. A more recent study by the mutual fund gurus at Morningstar concluded: