Your Five-Star Mutual Fund Is Probably Going to Fail You

When you're first getting started with , there's a tempting and seemingly logical strategy for picking mutual funds: just choose the ones that have been doing the best lately. It makes sense, right? We’re drawn to winners. This is why a huge amount of investor cash—over 150 percent of net flow in 2016—pours into funds with a four or five-star rating from Morningstar.

The problem is, this strategy is deeply flawed. Those star ratings, which many people rely on when figuring out , are heavily weighted toward short-term performance. For a fund with a 10-year history, the last two years alone make up 35 percent of its rating. For a newer fund, that number jumps to a staggering 65 percent.

So, does chasing these high-flying, five-star funds actually work? Not really. According to a 2014 study by the , only 14 percent of funds that had a five-star rating in 2004 still held that top spot a decade later. Half of them had tumbled down to three stars or fewer. This points to a powerful force in finance: "reversion to the mean."

The Powerful Pull of Average

Reversion to the mean (RTM) is the simple idea that exceptional results—both good and bad—tend to return to the average over time. Today’s winners often become tomorrow’s average performers, or even losers.

The data from the fund industry confirms this in a big way. Let’s look at a study comparing the performance of all actively managed U.S. equity funds over two separate five-year periods: 2006–2011 and 2011–2016. The funds were sorted into five groups (quintiles) based on performance, from best to worst.

Here’s what happened to the top-performing funds from that first period:

Only 13% managed to stay in the top group for the next five years.
A shocking 27% of these "winners" plummeted to the bottom group.
Another 25% fell to the second-worst group.
Worse yet, 10% of them didn't even survive the next five years.

And what about the worst-performing funds from the first period? Their story is even more telling. A full 17% of these laggards shot up to the top quintile in the next period—outperforming the original winners! Only 12% of the losers stayed at the bottom. The results from this kind of are almost completely random.

It Wasn't a Fluke

You might think that was just a weird five-year stretch. So, the same analysis was run for the preceding periods: 2001–2006 and 2006–2011. The results were virtually identical.

Of the top-tier funds from 2001 to 2006, only 15% stayed on top, while 20% fell to the bottom. Once again, the bottom-feeders did better; 18% of the worst-performing funds from the first period ended up in the top quintile in the second. These numbers are amazing because they show how little persistence there is in performance when . The idea that a manager’s skill will carry over year after year just doesn’t hold up. We are, as one author put it, "fooled by randomness."

The stars of the mutual fund world are often just meteors—they burn brightly for a moment and then vanish. When , it's crucial to understand a few things about that fund you're considering based on its hot streak:

How long will that star manager stick around?
Can the fund achieve the same results when it’s ten times larger?
Will the market conditions that favored the manager's style continue?

Chasing past performance is a hazardous game, one that almost guarantees you’ll underperform the market itself—a return you could have easily captured with a simple index fund. These are key considerations when seeking solid .

Why We Keep Making the Same Mistake

If the data is so clear, why do we keep falling for this? Nobel laureate Daniel Kahneman explains that our brains are wired to find causes for everything. We see a winning streak and invent a story about a brilliant manager. The truth, he says, is that reversion to the mean "has an explanation but does not have a cause." It’s just statistics at work.

Don't just take my word for it. Experts have been shouting this from the rooftops for years:

pointed out that picking a top-quartile fund gives you a less-than-chance probability of it staying there. In fact, you have a higher chance of picking a future dud than a future winner.
, a respected investment manager, famously said it would take anywhere from 20 to 800 years of performance data to statistically prove a manager is skillful, not just lucky. His own money? It's in Vanguard index funds.
of the put it most bluntly: “Buying funds based purely on their past performance is one of the stupidest things an investor can do.”

The old warning, "past performance is no guide to the future," isn't just legal jargon. It's the simple, undeniable math of the market.