Even Yale says to stop chasing investment returns

Studies of investor behavior suggest that most are guilty of what Albert Einstein defined as insanity: doing the same thing repeatedly while expecting a different outcome. Now, even the legendary manager of the Yale Endowment says it's time to break the cycle.

Too many investors believe outperforming active managers will continue outperforming, so they hire managers with great track records and Morningstar ratings. When those managers come up short, investors fire them, only to repeat the process. They fail to ask the simple question: "If the past has already proven a poor predictor of future performance, why will it work this time? Am I doing something different in the process to prevent the same mistake?"

David Swensen, the celebrated chief investment officer of the Yale Endowment Fund, provided compelling evidence of investors behaving badly. Swensen noted that investors respond to industry come-ons from ads trumpeting Morningstar four- and five-star ratings -- despite Morningstar's own acknowledgment that simply ranking funds by expense ratios is a better predictor of future returns. Swensen found that in 2010, investors redeemed $152 billion from one-star, two-star and three-star funds and placed $304 billion in four-star and five-star funds. During the crisis of 2008, investors added $47 billion to four-star and five-star funds while withdrawing $174 billion from one-star, two-star and three-star funds.

Yet the evidence from studies demonstrates that all this churning costs investors dearly, while enriching Uncle Sam who collects more tax revenue. Of course, the brokers and advisors who promote all the counterproductive behavior do so to justify their compensation. Consider just how costly the behavior is.

Morningstar found that if mutual-fund investors in 2000 had simply bought and held their funds for 10 years, their investment outcomes would have improved by an average of 1.6 percentage points per year, meaning investors lost tens of billions a year through their return-chasing behavior.

Swensen asks the question, "Why isn't there more of an outcry?" He said believes the answer lies in investors naively trusting brokers and advisers. He adds that most investors understand too little about financial markets to make informed decisions and gather too little information about portfolio holdings to evaluate results. Investors like to believe they're doing well, even when they're not, as the truth is too painful to confront.

I agree with Swensen when he says one solution is to require the mutual-fund industry and adviser industry alike to be held to a fiduciary standard of care, one that puts clients' interests first. Of course, there are many in both industries fighting that proposition, even though it's in your best interests, because it would be economic suicide for them to face those facts.