The April 2004 issue of Scientific American had an article by Barry Schwartz on "The Tyranny of Choice." He made a distinction between "maximizers" who aim to make the best possible choices and "satisficers" who aim for good enough, whether or not better selections might be out there. His research suggests maximizers are less happy since the availability of many alternative choices can lead to high expectations and then regret.
As an investor I have always been something of a "satisficer". Early on, I picked among no-load funds when the choices were fairly limited. I found that investing in a good (but not the best) fund over an extended period in a bull market resulted in very satisfactory results. As the number of no-load funds increased and the choices started to become overwhelming, I thought long term and low expenses, and picked funds I hoped would be excellent. But I always understood picking the fund that would turn out to be the "best" fund was a low probability exercise. I recommend that you pick mutual funds thinking like a "satisficer" and not a "maximizer". All the pressure will be on you to pick funds like a "maximizer". Newsletters are always suggesting they can pick the best funds in advance. Magazines are always touting the "best" funds to buy now. It is easy to convince yourself that your goal should be to pick the "best" fund. After all, why aim to pick a good fund and not the best?
It is important to understand that there really are no good tools to help you pick the "best" fund in advance. Past performance, which is one of the few guides available, is not a perfect predictor. In fact, just picking a fund that will perform better than the average in the future, is an extremely challenging task.
Investing in funds based on market indexes has been popular and successful precisely because their expenses are low and their performance is at least average. Remember that "average" should not discourage you since average is roughly better than half the funds that will be below average. I suspect that by aiming for the "best" and not just very good, you will automatically choose a riskier fund which means there is a higher probability of below average performance.
If you invest like a "maximizer" you are likely to be tempted to keep switching from one hot fund to another hot fund. This is generally recognized as a recipe for poor investment results. If you try to pick the "best" fund, you are likely to fail. If you believe that you are failing, you are more likely to give up on the long term investing that can lead to success.
But investing like a "satisficer" does not mean you should be overly passive about mistakes or funds that disappoint. Web sites like www.fundalarm.com can help you to monitor the performance of your funds compared to averages. Funds that under perform over an extended period of time should be re-evaluated and then the fund should be sold if there is no justification to keep it. Funds with new management should be watched carefully in order to see if expenses or philosophy change.
Investing like a "satisficer" does not mean you should ignore asset allocation issues. In fact, by spending less time trying to pick the "best" fund, you should have more time to focus on a suitable asset allocation. Picking the right asset allocation can lead to better investment results. And it appears to me that picking the right asset allocation is far more likely than picking the "best" mutual fund in advance.
William Bernstein believes that to be a successful investor you need these basic skills and character traits.
1. Mathematical understanding
2. A sense of history
3. Toughness (to ride out inevitable losses without panicking and making bad decisions)
4. Independence (to stick to your plan and ignore constant blandishments to make unneeded moves)
I think the mathematical understanding needed is an appreciation of compound interest and the ability to understand charts and graphs. I think the sense of history needed can most easily come from studying those charts and graphs that plot stock market history. I think that a good start on the toughness and independence required can come from thinking like a satisficer.