Why Do Smart People Do Dumb Things?

Last Updated May 5, 2010 1:02 PM EDT

You've no doubt heard the SEC disclaimer that past performance doesn't guarantee future success. But do you remember it when you're investing in a new fund? A new paper shows that many investors ignore such a warning. The working paper "Worthless Warnings? Testing the Effectiveness of Disclaimers in Mutual Fund Advertisements" provided some interesting results.

Participants were shown performance advertisements for outperforming mutual funds. They were then asked how likely they were to invest in the funds and what they expected the funds to return. Some of the advertisements had no disclaimer, while other advertisements varied on how prominently they featured it. The authors found that "people viewing the advertisement with the current SEC disclaimer were just as likely to invest in a fund, and had the same expectations regarding a fund's future returns, as did people viewing the advertisement with no disclaimer whatsoever."

The authors went on to say the current disclaimer is ineffective because it's too weak. It notes that investors may lose money, but doesn't say anything about high past returns poorly predicting high future returns.

Interestingly, the authors did find "that a stronger disclaimer -- one that informs investors that high fund returns generally don't persist (they are often a matter of chance) -- would be much more effective."

It's amazing to me that so many people follow the surgeon general's warning about the dangers of smoking, yet ignore the SEC's warning about the dangers of relying on past performance. Investors are also ignoring the American Law Institute's Prudent Investor Rule that states: "there is little correlation between fund managers' earlier successes and their ability to produce above-market returns in subsequent periods." We know this because several studies have shown that money flows to top performing funds. For example, one study showed that 97 percent of money flowing into no-load equity funds for the time period studied went to four-star and five-star funds.

There are hundreds of studies on the subject of past performance of money managers as a predictor of future performance. Fortune magazine noted that: "Despite volumes of research attesting to the meaninglessness of past returns, most investors (and personal finance magazines) seek tomorrow's winners among yesterday's. Forget it...The truth is, much as you wish you could know which funds will be hot, you can't -- and neither can the legions of advisers and publications that claim they can."

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.