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The Funds That Got Away and Why You Should Let Them Go

Beware of hindsight bias when comparing what you own with what you wish you owned.

Dan Culloton, 09/10/2010

The analyst's son cast for his last fish of the last night of summer vacation. Moments later, after a big splash and a mild oath, all the teen had was a snapped fishing line and conjecture about what swam off with his bait. The one that got away already has grown large enough to eclipse the memory of all the other fish he caught the previous week.

Like young fisherman, investors fret and dream about missed opportunities. Lots of investors find themselves more obsessed with the investments they should have made than with ones they actually bought. You can learn from studying past decisions, but pining after today's big winners because you didn't buy them yesterday can get you in trouble.

You could fall prey to hindsight bias, thinking that the historical results of a hot fund or asset class were inevitable and thus easy to predict. From there it's easy to conclude the future will be just as foreseeable and that tomorrow's top performer will seem like a no-brainer. Furthermore, fixating on the results you could have had instead of how you achieved the results you got can lead you to misjudge your strategy and make unnecessary alterations. Just because you took a pass on a fund that turned out to be a world-beater doesn't mean you didn't have sound reasons to do so or that you're not following a legitimate process.

Consider some big ones that have gotten away from the analyst over the years.

After the Gold Rush
More than a decade ago a colleague pounded the table for gold. A small allocation to gold or gold mining stocks could add diversification because they zigged when the equity market zagged, one argument went. Gold prices also were at historic lows and due for a rebound, went another. Did the analyst listen? No. He allocated nothing to gold and sat out the typical precious-metals fund's nearly 23% annualized 10-year gain (the best of any Morningstar peer group) through Sept. 3, 2010.

He had reasons. Yellow metal was unpredictable, generated no income, had no real return, and hadn't done anything for decades. Plus, you couldn't buy gold bullion exchange-traded funds at the time, just funds that owned precious-metals mining stocks, which were subject to lots of company-specific risks. The analyst didn't think he could sleep with that in his portfolio.

The Once and Future King
Later, another colleague initiated coverage on a newish fund saying it had "great appeal for dedicated value investors." The fund had been around only since December 1999 but had been on a tear. The manager was an iconoclastic value investor who shunned benchmarks and wasn't averse to holding cash if opportunities were scarce or loading up on favored sectors and stocks when they were plentiful.

It caught the analyst's attention, but he remained a spectator. The fund's fees were a bit higher and its track record shorter than those of the funds the analyst already owned. The contrarian in the analyst also balked at buying a relatively young fund after a hot streak.

The streak continues. It was Fairholme FAIRX, run by Bruce Berkowitz who eventually became Morningstar's Domestic-Stock Manager of the Decade.

Now for Something Completely Different
Years later the analyst covered and owned a contrarian, all-cap value fund in a slump. He had faith in the manager. The fund's advisor and board, however, didn't and replaced the manager with another who was no less a contrarian but who traded more often. Yet another colleague vouched for the new manager's track record at a previous fund, but the analyst withdrew his recommendation and sold the fund because the change had transformed it from a low turnover, traditional contrarian value fund into a faster-trading vehicle with a more flexible notion of value.

About 18 months later the fund, Vanguard Capital Value VCVLX, had bounced off the mat under new manager Peter Higgins to become one of best post-financial crisis domestic-equity funds.

What did the analyst do wrong? Other than not listening to his colleagues, not much. His actions were mistakes only if you define success as always owning the best-performing funds, which no investment plan, no matter how sound, will ever do. You may feel like an idiot for not buying Fairholme in 2000, but even well-thought-out investment schemes will let some great investments through their nets. So before bemoaning your missed chances, reconsider your rationale for choosing the investments you have and whether they've panned out.

Developing what The Black Swan and Fooled by Randomness author Nassim Nicholas Taleb calls "alternative histories" about the great investments you missed also can put things in perspective. What, for example, would have been the cost to the analyst's portfolio if precious-metals equity funds hadn't rallied or proved too volatile for his delicate constitution? What if he had dumped all his core holdings for Fairholme just in time for it to flame out? What if Vanguard Capital Value proved to be the Evel Knievel of mutual funds, attempting astounding feats, but breaking scores of bones in the process?

When an investment tops the charts, few people, whether they hold it or not, imagine what could have happened if things had played out differently. Doing so can shed light on the risks you took or avoided. It made the analyst feel a lot better. He realized most of the funds he owns are no slouches. Nearly all of them have well-below-average expense ratios and turnover rates, and well-above-average manager tenure and long-term category rankings--traits that increase the odds of him achieving his goals. So, he'll try not to fret anymore about the funds that got away this past decade. He expects to hear much more about that fish, though.

Dan Culloton is an associate director of fund analysis for Morningstar.

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