In F. Scott Fitzgerald's short story, The Rich Boy, he has this to say: "Let me tell you about the very rich. They are different from you and me."
A recent article in The Economist took issue with the commonly held belief that small investors are the dumb money, buying before the markets crash and selling before they recover, and rich people are more savvy, reaping the rewards of their wealth.
Everyone knows that rich, sophisticated investors buy hedge funds. Not just individual wealthy investors, but pension funds, trusts and endowments as well. These investors can afford the best advice, which is beyond the reach of average investors. A bevy of investment consultants, private banks and others meet with them in their fancy offices to dispense their investment insights, no doubt over elegant catered lunches.
A study determined how hedge fund investors selected funds from 1994 to 2004. The selection criteria was quite simple: They invested in funds that had stellar performance the previous three quarters. Brilliant!
Unfortunately, there was no evidence that past performance of these funds was indicative of future performance. That means that poor performing hedge funds were just as likely to perform well in the future as outperforming ones.
Where have you heard that before?
Less affluent investors have been making the same mistake of chasing returns for years. The trap they fall into most often is being influenced by their broker's recommendation of mutual funds rated five stars by Morningstar.
A recent study by Tom McGuigan and Tim Courtney of the Burns Advisory Group looked at 248 funds rated five stars on December 31, 1999. The study found that, ten years later, only four had the same rating. 87 of them had gone out of business. Of the remaining funds, the average rating was under 3 stars. None of the funds in the best performing asset class of small value funds was rated five stars in 1999.
It gets worse. The average return for the five-star funds over the decade measured was worse than the average return for all funds, except in the international category, which beat the average by a tiny fraction of 1%.
I suppose the "little guys" shouldn't despair. It turns out the rich and the not-so-rich are both duped by brokers and advisers who make big bucks claiming they can "beat the markets."
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