Why top performing mutual funds do not always remain top performers

If you are choosing mutual funds by looking at which schemes delivered the highest returns in the previous year, you need to rethink your strategy.

Funds that suddenly appear at the top of performance rankings often attract attention quickly, especially after strong rallies or positive media coverage. But recent returns alone rarely tell the full story.

Markets change constantly, leadership rotates between sectors and funds that performed exceptionally well in one phase may struggle in the next. As a result, investors who chase last year’s winners often end up entering too late and building portfolios based more on short term momentum than long term suitability.

Why recent performance is compelling

Recent performance gives an assurance of future performance, thus creating confidence.

People always believe in what is new because their decision making process is influenced by regency bias – they give more preference to something they saw or experienced recently.

The problem of relying on the most recent performance is in the dynamic nature of the stock market.

What worked yesterday cannot work today.

Past performance is valuable and informative but it does not guarantee anything.

Top performing funds may just be beneficiaries of the prevailing conditions in the market

Sometimes, funds perform exceptionally well as a result of the market condition prevailing in the market. This implies that they benefit from the current trends in the market.

Examples of such trends include sectors of technology, energy, small caps and any other industry that has shown great development. This means that such kinds of mutual funds are likely to show positive performance only for a short time.

Thus, by the time one decides to invest in the funds, it might already be too late since its returns may start dropping due to market leadership rotation.

Investing in mutual funds based on their recent performance leads to poor timing

It’s a common mistake to enter the market only when there are already good signs and leave it when it starts to underperform.

By doing so, one ends up with a short term gain and no future benefits from such kind of investment. In addition to this, switching from fund to fund based on their ranking is likely to make the whole decision making process erratic and undisciplined.

Fund suitability should come first rather than performance ranking

One should consider his/her suitability and needs rather than the fund’s performance ranking while making an investment decision.

What matters here is the consistency in choosing a suitable fund.

If a fund is highly volatile, then it may be profitable but it doesn’t mean that it will work for you. In addition to this, the choice of the fund should depend on your objectives.

Therefore, the suitability of a fund to your personal needs is vital.

How long-term track record makes decision making easier

Rather than relying on the fund’s performance in one year, it would be reasonable to pay attention to its performance in several years. In this case, one would be able to see whether the fund has a consistent performance or not. Besides, he/she will be able to estimate its level of risk and return in general.

Thus, considering fund management, portfolio strategy and expense ratio becomes possible.

Why patience increases chances of success in investing

Investments should be made in accordance with a previously developed plan and not based on current trends.

While trying to find the funds with the best performance, one may be disappointed in his/her results because market rotates. Leadership keeps changing and thus, the best mutual funds keep changing.

Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to consult certified experts before making any investment decisions.