Do you know how most of the investors select the Mutual funds ?
Well, the go with old school method of checking the ratings. Yes, to investors ratings and number of stars mutual funds have still matter a great deal.
You can pitch in the best idea and pick up most successful research methodology, your client is most likely to go with one that has highest ratings. To them there is nothing beyond the wall of stars and ratings in this industry.
But is it wise to focus this much solely of rating ? Well absolutely not!
And here it is why:
They are not any classification system:
Today, talking about star ratings is a way of checking customer's opinions and critics regarding any product or service.
People give star rating everything these days, be it a movie or a restaurant. This new concept of star rating has overshadowed the true essence of stars.
The concept of stars.
The concept of stars started with rating the top restaurants and tourist hotels. You might have heard people talking about "4 star restaurant" which used to be and still is a big thing.
The standard restaurant with basic comfort use to get one star, the comfortable one would manage to get two stars while the elite luxury hotels were on the top of the game with five stars.
The star system was used to differentiate an elite class restaurant from a normal one.
However, unfortunately with the Mutual funds, the concept of classification is no-where near them. A mutual fund with 5 stars has no extra bells if compared with the one stared mutual fund.
Is it worth to chase the Best performing mutual funds?
When it comes to most important component of mutual funds, it is hands down its performance.
When people see a mutual fund with 5 star ratings, in their mind they develop an idea that the performance of this fund must be spectacular.
Most of the time people look at the ratings to check how it performed last year. However, what people do not understand is that this term chasing performance does not work every time.
Let's suppose that a mutual fund did exceptional good last year. Due to its amazing performance all you see is 5 star rating which is justified.
However, what you do not understand is that there is no rule or logic which explains that if a mutual fund did well last year, it is going to be equally good this year as well.
Yes, there is no guarantee that a mutual fund will perform same each there.
Similarly, a mutual fund with 1 star rating based on the performance last year might end up doing exceptionally good this year.
This is why the ratings of the mutual funds can deceive the investor and they might end up making the wrong choice just because they relied on the rating of a mutual fund.