The Problem with “Hot” Investments

About once a week, I take a trip to my local library to read up on the latest information about personal finance. I’ll grab current issues of all of the personal finance publications like Money and Kiplingers along with a newspaper or two and whatever personal finance books are on the “new release” shelf. I’ll then camp out at one of the back tables and do some reading.

It doesn’t take a genius to realize that most of the time those magazines are simply loaded with articles talking about “hot” investments. The magazines provide giant lists of mutual funds and stocks that have seen a very nice short-term return. The text of those articles make it sound like the readers should be putting all of their money into these funds now, now, now!

I flip directly past these articles and look for something that’s actually useful.

Why do I look at these types of articles and specific investment recommendations with such disdain? There are several reasons.

Past Performance Is Not an Indication of Future Returns

You have a fund that’s doing well during a boom market? That’s great. How will it do during a down market?

You might be able to point at past evidence, but the truth is that no one knows for sure. No one knows which sectors are going to get hammered when the market goes down. No one knows which sectors are going to cool off and which other sectors are going to heat up in the next few years.

Just because a fund did well last year – or even the last few years – isn’t an indication that it will do well in the future. The best individual investor of the past fifty years or so was probably Peter Lynch, and he only has that mantle because he had a very good run managing one mutual fund during the 1980s – but during the middle part of the decade, it actually did worse than the S&P 500 (’84 to ’87) and his last year saw a loss for the fund.

Another problem is the hedge fund factor. If someone is running a mutual fund and is doing a really good job and generating great returns, it’s very likely that a hedge fund will come calling and hire that person for boatloads of cash, thus eliminating the advantage that fund once had. It’s rare to see funds that are run year after year after year by the same people.

Simply put, a particular investment might be doing great this year, but that’s no guarantee that it will do great next year.

The Freshest Fruit Is Already Picked

By the time you actually read a list like this in a personal finance publication, the contents of those lists have already been thoroughly combed by investment houses. If those investments are actually bringing any innovation to the table, it’s being co-opted by other investors, which means that the investment had better come up with a new edge very soon or you won’t see nearly as much value.

For example, let’s say a magazine uses a good formula to generate a list of the twenty most undervalued stocks. By the time you see that list, a similar analysis – probably with a lot more depth – has already been done by the large investment firms and if there’s really any gold to mine there, those stocks have already been exploited.

You’re not going to get insider information or special tips from the pages of Money, Kiplingers, or the Wall Street Journal. The amount of time it takes for those publications to move from research to written article to print gives every big investor more than enough time to match that research and exploit it.

What you read is just the leftovers.

Articles Are Written and Influenced By Salesmen

Sometimes, it’s even worse than leftovers – it can sometimes be material designed to make profit for other investors.

Just like any other company, investment houses sell products. They want you to buy their investment products so that they will be the ones to make money from the annual fees, not the competition. Other banks – particularly investment banks like Goldman Sachs or hedge funds – want you to purchase things so they can make money in other ways, like buying long on investments that they’re promoting or short selling investments that they’re trashing.

It makes complete sense for those companies to try to find a way to get their funds talked about in financial magazines. It’s part of doing business.

In less reputable publications, salespeople can directly influence articles – even sometimes writing the articles themselves – to make their investments seem really, really good. I don’t think that Money or Kiplingers do things like this, but I’ve certainly seen websites that I can say with high confidence that the material was written by people wanting to manipulate the behavior of others when it comes to certain investments.

Even in more reputable places, salespeople from the big investment houses will promote their mutual funds to the writers of those publications, using personal contact and relationships to help their funds make it into the article.

In that case, the writers aren’t doing a bad job in any way – every writer is susceptible to writing about the things they know and the things they hear, and salespeople will try to fill that zone with info that’s positive toward their investments and their business.

The Information That Matters Most (Usually) Isn’t There

For me, the piece of information I want to know most is what the fees are like for that investment. What will it cost me to by in? What’s the annual fee? What’s the transaction fee?

You rarely see that information mentioned in those kinds of articles. In the better lists, they might have an “expense ratio” column – but that’s a maybe. Often, that information isn’t included. Most of the time, the investment firms themselves are compared with only a minimal look at their fees.

In other words, the expectation that these articles have is that you will compare funds largely based on past performance. Not only that, these funds are the ones that have been pre-selected by the magazine, often for reasons completely unclear to the reader.

Past performance is pretty far down the list of factors that I care about when it comes to choosing how to invest.

If “Hot” Investment Advice Is Useless, Then What?

I’ve been investing in various things since 2002 and I’ve yet to use a single piece of information from any articles like these. Instead, I use a very simple process for figuring out what I should invest in.

First, I figure out how much risk I’m willing to stomach. This is usually directly connected to how many years it will be before I expect to tap the investment. I usually won’t invest in stocks if I’m worried about preserving the balance – if I need a certain minimum, I’m willing to give up a stronger rate of return, because risk and reward are usually related.

Next, I decide if I’m going to invest in stocks at all. If it’s less than five years, I avoid stocks entirely, for example. If it’s between five and fifteen years, I usually split things between domestic stocks and other things. If it’s further out than that, I’ll put it in domestic stocks and some international stocks.

If I am going to invest my money in stocks, I look at funds offered by companies that I’ve done business with successfully in the past or that have a strong reputation for low fees. I usually start with Vanguard, but I look at offerings from a few other companies, most notably Fidelity. I have personally had good experiences with these companies and I know their offerings to be reliable and honest.

I compare funds that have the same level of risk. I’ll look at everything offered by each company that has a low level of risk if I’m looking at a low-risk low-return situation. As my risk goes up, I add in higher risk investments.

This is usually easy to do. The companies I usually look at – Vanguard and Fidelity first and foremost – offer tools to make this very easy to figure out.

I mostly look for the lowest fees in that risk class. That’s my number one point of comparison. I’ll only move on to other factors, like history, if the fees are pretty close to each other. In other words, I pretty quickly drop all but the “top ten” or so in terms of lowest fees, then I look at each of them a little more carefully.

That “top ten” is basically my own personal top ten list. I don’t need a magazine to find it. I can just look it up myself with just a few minutes of work.

Final Thoughts

Most financial publications have a lot of good material in them. I’ve deeply enjoyed articles in these publications on getting into the right mindset, spending less money, and planning for future events like college education. The advice in those articles is almost always sound and sensible.

However, I find the lists of “hot” investments to be quite a bit less useful. Usually, it’s because I don’t know the real criteria behind those investments and I don’t consider the returns of the last year or two to be all that vital.

Do your own homework – and know why you’re doing it. There’s nothing wrong with looking at a list of “hot” investments in a magazine, but it shouldn’t be the basis for your long term investment decisions.

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