Perils of chasing the mutual fund with the highest recent return

Sunday's Washington Post has regular feature where three investment experts are asked a specific question to guide personal finance. Many times there's variation in their answers. This Sunday -- last week being the week that was -- they all had the same answer.

The question was:

What is the biggest mistake investors make?

Some excerpts of the answers:

Greg Evans, first vice president, investments, at the Millstone Evans Group of Raymond James and Associates in the District.

The biggest mistake investors make over and over again is to pile into the asset class or classes that have done the best over the past few years at inflated prices.

Psychology comes into play as people tend to do what others are doing.

....

Stuart Ritter, certified financial planner for T. Rowe Price Associates.

It's believing that the behavior of markets the last few weeks, months or years will be the same in the future.

....

Wayne Zussman, president of Triton Wealth Management in Annapolis, Md.
...
Because the best-performing asset class varies from year to year and is not easily predictable, having a portfolio of different asset classes is more likely to meet your goals and reduce the volatility and risk factors within your portfolio.

Read their full answers here.

And yet, the paper stokes the "chase the return" mentality in its feature business article that same day.

It's not wise to chase the fund that had the highest returns last year. But people do (contrary to the predictions of economic theory!). A larger question is what incentives does this behavior create for fund managers? Economist Robert Frank, writing in Sunday's New York Times presents a theory:

If one fund posts higher earnings than others, money immediately flows into it. And because managers’ pay depends primarily on how much money a fund oversees, managers want to post relatively high returns at every moment.

One way to bolster a fund’s return is to invest in slightly riskier assets. (Such investments generally pay higher returns because risk-averse investors would otherwise be unwilling to hold them.) Before the current crisis, once some fund managers started offering higher-paying mortgage-backed securities, others felt growing pressure to follow suit, lest their customers desert them.
...
The new mortgage-backed securities were catnip for investors, much as steroids are for athletes. Many money managers knew that these securities were risky. As long as housing prices kept rising, however, they also knew that portfolios with high concentrations of the riskier assets would post higher returns, enabling them to attract additional investors. More important, they assumed that if things went wrong, there would be safety in numbers.
...
A high proportion of investors are simply unable to stand idly by while others who appear no more talented than them earn conspicuously higher returns. This fact of human nature makes the invisible hand an unreliable shield against excessive financial risk.

Read Frank's essay here.

The "safety in numbers" point is important. It's part of the moral hazard that exists in the system: participants anticipate the government will step in with a rescue. And they are correct in that belief: once a crisis exists the government will step in. As Tyler Cowen says, "ex post the bailout is always on its way so this is simply something we have to live with."