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Why the "top performing" funds may not be the best investment

A 2007 mutual fund study unveiled a telling paradox for individual investors: the average investor underperformed the average mutual fund by between 1.82% and 2.28% on an annual basis. While it seems inexplicable that everyday investors were unable to even match the average mutual fund performance, the explanation, in fact, is really quite simple. The majority of investors continually gravitate towards the sectors and funds with the top short-term results. Unfortunately, these sectors and funds rarely remain as the top performers, and often become among the weakest, leaving their investors with below average returns. In order to understand this seemingly irrational behavior of buying high and selling low it is important to understand why investors incessantly chase short term performance and why mutual funds are unable to maintain their above average returns. The good news is that there are some relatively easy steps that investors can take to counteract some of these factors leading to low returns, but first an explanation of the causes is necessary.

In order to facilitate an explanation of the dynamics confronting individual investors when choosing a mutual fund, it is first important to examine the ways in which the mutual fund industry operates. Mutual fund companies make money by increasing the amount of assets that they manage by either adding new investors to existing funds or by creating new funds. In both cases the mutual fund company will have to market the funds either directly to investors or through the intermediaries, such as financial advisors, that individuals go to for investment advice. All of this marketing costs money and like any business the mutual fund company will spend their money in a way that will produce the best results. As advertisers know, humans are pre-programmed to search for patterns and extrapolate those patterns into the future. Naturally, mutual fund marketing departments will focus on the funds that are doing the best, knowing that in an almost pavlovian fashion investors will gravitate towards those funds by naively assuming that the returns will simply continue into the future. High returns also gain the attention of the press and the top funds and their managers are profiled along with numerous convincing reasons that their current success will continue unabated into the future. It is only a matter of time before cocktail party conversations are filled with

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