The wrong way to pick funds

(Money Magazine) -- Photographer friends tell me that if you're picking out a point-and-shoot camera you shouldn't focus much on the megapixels. That measure of a camera's resolution is hyped by manufacturers, but most cameras on the market give you all the pixels you'll need.

So when I was buying a new camera recently, I chose ... the model with more megapixels.

• Facebook
• Digg
• Twitter
• Buzz Up!
• Email
• Print
• Comment on this story

CDs & Money Market

MMA	0.69%
$10K MMA	0.42%
6 month CD	0.94%
1 yr CD	1.49%
5 yr CD	1.93%

Find personalized rates:
 

Rates provided by Bankrate.com.

Call it the data dazzle. Your mind tends to hook on to any number that helps you compare various choices, even when you know the information isn't actually helpful.

I thought of this after reading a proposal to fix the retirement system from the Squam Lake Working Group, made up of some of the nation's top economists. One of their ideas is to create a simple one-page disclosure label for the mutual funds in 401(k) plans.

You'd see data such as the fund's costs and its likely risk. What you wouldn't see: its performance record.

"We don't think it's very informative," says Dartmouth economist Kenneth French, who worked on the proposal. French is also a director of a firm that runs low-cost funds, which would tend to look good in this light. But I think he also has the evidence on his side here.

The past is past: At least when I paid for extra megapixels I got them. But performance numbers represent returns that have already been earned. Your returns are in the future, and it's notoriously hard to pick tomorrow's winners and losers. Ask anyone who bought Bill Miller's Legg Mason Capital Management Value fund in 2006 (see below) -- or sold it in 2008.

Returns push your emotional buttons: Performance stats can be worse than uninformative. They can actually de-inform, making you forget about data that matter. Although low expenses add up to a big performance edge over time, nobody ever fantasized about paying just 0.25% for a fund.

But when you see a fund that has earned 15% annualized returns over a decade -- as some emerging-markets funds have -- it's hard not to imagine how cool it would be to own a piece of that.

Managers know the game: Returns drive fund sales. That gives managers an incentive to seek short-term glory at the expense of long-term strategy.

One way for a fund to look good, says Santa Clara University finance professor Meir Statman, is to invest outside its category. A fund that focuses on large U.S. companies might add shares of small tech companies when they turn hot. That will score good relative numbers for a while but expose investors to unexpected risks.

If you just can't ignore performance numbers, make it a rule to look at them last, after you've made a short list of funds with low expenses and experienced managers. You'll be two steps ahead of the game.