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6

Don't Buy These Top-Performing Investments

After the carnage we endured in the market last year, investors are eager to get their portfolios and their dreams of retirement back on track. Unfortunately, if history is any guide, many of them will go about it exactly the wrong way -- by chasing performance.

While it may seem like an easy fix to identify which stocks or segments of the market have been outperforming lately, and throw your money at them in the hopes that they'll continue their winning ways, this is a surefire way of sandbagging your portfolio.

Chasing one's tail
Let's examine which investments have landed at the top of the charts so far in 2009. According to the Morningstar Principia database, the following five funds are all near the top of the class:

Fund

Return*

Direxion Daily Technology Bull 3X Shares (NYSE: TYH  )

110.0%

Direxion Daily Emerging Markets Bull 3X Shares (EDC)

107.2%

ProFunds Ultra Latin America (UBPIX)

100.8%

Dreyfus Emerging Asia (DEAAX)

100.4%

JP Morgan Russia (JRUAX)

86.9%

*Performance year to date through July 31, 2009.

Wow! Those are some pretty hefty returns. But before you go imagining ways to fit one of these highfliers into your portfolio, take a closer look at each of these funds. You'll find several reasons why they aren't appropriate for most investors.

First of all, the two Direxion exchange-traded funds and the ProFunds offering are leveraged funds, which offer investors a multiple of the index that the funds are tracking. The ProFunds option offers 200% the return of its Latin American index, while the Direxion funds offer 300% of the daily return of their respective technology and emerging markets indexes! To me, that sounds more like gambling than investing.

In addition, most of these options are very narrowly focused, investing in just one industry or one emerging economy, like JP Morgan Russia. It's no surprise that funds like these land at the top of the performance charts -- they're also the most likely to land at the bottom of the charts next year.

These risky, narrow funds are highly volatile. In fact, of the three of these funds that were in existence in 2008, each of them lost between 61% and 87% last year alone! Most investors don't have any need for narrowly focused investments like these. Fools should stick to well-diversified, broad-market options instead.

While the Dreyfus fund invests more broadly across emerging markets, it is highly concentrated, with more than 79% of assets in just three sectors, and 55% allocated to two countries. That means concentrated bets, which could sink the fund if they don't pan out. Furthermore, the fund is relatively new, with less than two years of a track record. That's a bit too soon to make a solid judgment call on the managers' long-term skills.

Lastly, as is typically the case with highly specialized funds, each of these top performers is ridiculously expensive. Whereas the average mutual fund sports a 1.3% net expense ratio, these chart-toppers range in price from 1.66% to 2.01%. The Direxion ETFs are slightly cheaper at 0.94%, but that's still much higher than the cost of the average exchange-traded fund! That's more than any investor should be willing to pay for the privilege of owning any fund, no matter how outsized the gains may be in any short-term period.

The cost of folly
While it can be incredibly tempting to chase returns, keeping a steady head as trends come and go is one of the key attributes of successful long-term investors. In fact, a study performed by the Financial Research Corp. (FRC) found that on a rolling return basis from January 1990 through March 2000, the average mutual fund's mean three-year return was 10.92%, while the average fund investor gained only 8.7% over the same period. The study attributes the difference to investors' habit of chasing performance, as measured by rising redemption rates and shorter holding periods.

A better way
So what does this all mean? Well, first of all, if you want to win at the investment game, you've got to move beyond short-term thinking. A longer-term, buy-and-hold focus is essential. You've got to look past the temporary ups and downs of the market and keep the long-run trajectory in mind.

Secondly, if you're shopping for mutual funds, make sure you're not using past performance as your sole criteria for selection. While it is perfectly OK to take longer-term performance into account, I would argue that it's more important to first find a fund with an experienced, long-tenured manager, low expenses, a consistent investment history, and solid performance in both good and bad environments. Once you've done that, see how it stacks up against its competitors' track records.

If exchange-traded funds tickle your fancy, make sure you stick to broad-market, well-diversified options like Spiders, Vanguard Dividend Appreciation ETF (NYSE: VIG  ) , or iShares NYSE Composite Index (NYSE: NYC  ) . And whatever you do, make sure you're not overpaying for ETFs -- buy the cheapest funds you can find that get the job done.

Of course, if you consider yourself a stock jockey, there's no better place to get investment ideas than from some of the brightest names in the business. For example, top manager Chris Davis of Selected American Shares (SLASX) has been adding to his position in tech companies like Google (Nasdaq: GOOG  ) and Hewlett-Packard (NYSE: HPQ  ) , while cutting back on big-name financials like JP Morgan Chase (NYSE: JPM  ) and American Express (NYSE: AXP  ) .

To get more of the inside scoop on how to invest your retirement-minded dollars, be sure to check out the Fool's Rule Your Retirement service. With your free 30-day trial, you will get access to a wealth of insider tips and hints to meet your retirement goals with plenty of room to spare.

There are worthwhile ways of rebuilding your portfolio, but chasing performance isn't one of them. By choosing the right investments and sticking with them for the long run, you'll be ahead of the pack, instead of chasing others.

Already subscribe to Rule Your Retirement? Log in at the top of this page.

This article was originally published June 18, 2009. It has been updated.

Fool fund expert Amanda Kish owns none of the stocks listed here. Google is a Motley Fool Rule Breakers recommendation. American Express is an Inside Value choice. The Fool's disclosure policy can't decide whether it'd rather be the chaser or the chasee.


Read/Post Comments (2) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 10, 2009, at 12:54 PM, Mrhowell13 wrote:

    Investing = gambling, you goof ball. Did you miss the Dow's fall from around 14,200 to 6,440? It's funny how financial advisors/writers like you were advising common folks to take on additional risk at Dow 14,200. Now you are suggesting not chasing performance at Dow 9,500? I suggest anybody who wants to make money in the market ignore the message of this article but pay heed to some of the investments mentioned here!

  • Report this Comment On October 06, 2009, at 8:36 AM, Company99 wrote:

    why the cry against 2x and 3x. Is it because then the common investor does not need analyst to recommend a particular stock. With the ETFs be it 1x or 10x all they need to know is which sector is right at the moment.

    many articles are written abt leverage being bad but all fail to come up with convincing and tangible reasons that they don't work.

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Amanda Kish
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Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter.

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