Stock valuations have a mind of their own. Most of the time, stocks tend to trade away from what we evaluate as fair value. They either trade below or above what we enumerate as fair value. Mutual funds can never be insulated from the influence of stock valuations.
Whether stocks are trading relative to their fair value has a deep bearing on future fund performance. When mutual funds own stocks trading way above their fair value, they may be expensive. Yet, investors tend to pour money into them exactly when they are too expensive.
Investors’ excessive reliance on past performance in decision making can hurt when valuations are extremely high. Conversely, when funds own good stocks at valuations below their fair value, they tend to be ignored. Investors show no interest when a fund’s near term performance looks soft. The lack of performance tends to be a dampener. But, buying such out of favour funds can be hugely profitable over the long term.
This is exactly how sensible investing should be done. Valuations rather than performance are a far superior driver, especially in times like the present. Mutual funds that own portfolios populated with expensive stocks are at risk. A better approach would be to buy funds with portfolios of sound stocks at reasonable valuations. Valuations, and not past performance, hold the key to future returns. Keeping minds open to change is crucial now, more than ever before.
“Price is what you pay; value is what you get.” – Ben Graham