Mutual Fund Ratings Are Best Ignored

The mutual fund industry has what I’d call an “expert problem.”  Simply put, the general sees investing in general and mutual funds in particular as complicated business.  Thus, they seek out the advice of experts.  Problem is, experts aren’t any better at predicting the future than anybody else, which actually isn’t all that surprising since the future, by virtue of not having happened yet, is pretty much completely unpredictable.  There are far, far too many variables at play to predict what a particular fund will do next week, much less next year or next decade.  But that doesn’t stop us from taking the advice of experts.  After all, what alternative do we have?  Something is better than nothing.

Mutual Fund Ratings Are Rarely Accurate

Mutual fund ratings are one way experts cash in on their perceived authority in the finance niche.  Unfortunately, much empirical research shows that experts are generally no better at predicting future market returns than everyday people.  Even the grand-daddy of all mutual fund ratings, the Morningstar Star Ratings, aren’t terribly useful for helping you pick winning mutual funds, according to a new study by Robert Huebscher.  According to Huebscher,

“…our analysis found that Morningstar’s ratings lost virtually all of their predictive ability when measured over a full market cycle…”

To be fair, it’s not really Morningstar’s fault their Star Ratings fail at predicting future returns.  In fact, Morningstar has repeatedly stated that the ratings are meant solely to give investors an idea of how a given fund has performed relative to its peers in the past and has never, at least not that I’ve heard, claimed the Star Ratings should be used for anything else.  Useful tool?  Perhaps.  But mutual fund ratings in general and Morningstar ratings in particular are only meant as a starting point to eliminate obviously horrible funds.

Of course, that’s not to say a free Morningstar account isn’t worth having.  On the contrary, the portfolio information, x-ray tool, and tax efficiency ratings are absolutely invaluable when shopping for a new fund to round out your asset allocation.  You just can’t take the mutual fund ratings too seriously.  After all, if Morningstar or anybody else knew where the markets were headed, they would be richer than Bill Gates.  Why bother selling advice when you could leverage everything for huge returns year after year?  If some expert is trying to tell you what to do with your money, ask them one simple question:  how are you investing your money right now?  If the answer is anything other than “exactly how I’m advising you,” run for the hills.  Then ask for proof.  If their investment strategy hasn’t made them rich yet, why do you expect it will make you rich?

Nobody Can Predict The Market

I could sit down and think of a thousand reasons the market should go up tomorrow, and maybe it will.  The problem is, there are far, far more than a thousand factors that influence the stock market.  There are literally tens of millions of tiny individual factors, insignificant on their own, that all add up to the market.  Sure, we can claim X new bill introduced in Congress or a bad earnings report from Y corporation caused the market to decline, but that’s nothing more than a poorly-thought-out guess.  It’s human nature to see patterns in the data even when none exist.  Fact is, nobody can predict what the market will do tomorrow, much less 10 years from now.  Ten thousand of the fastest super computers in the world all crunching the numbers at the same time don’t have a tenth of the processing power required to do that, and your brain certainly can’t compete.

The next time you’re asked what you think the market will do going forward, “I don’t know” is really the only valid answer.  Sad thing is, the same is true of the experts.