For Starters, Focusing on Ratings and Past Performance

Apparently, the familiar refrain that past performance is no indicator of future results isn’t top of mind when we decide where to invest our hard-earned money. You can’t really blame investors. Historical returns are trumpeted in advertising and fund disclosures, and past results are a reasonable guide in our own day-to-day experiences.

Indeed, when choosing a fund one of the few things you’re given is past performance, says Shlomo Benartzi, a UCLA professor and chief behavioral economist at Allianz. And, after you experienced so many things in your life where past performance will tell you a lot about what will happen, we’re now asking you to take the most salient available information you have and ignore that.

The good news is that more investors appear to be cost-conscious. The cost of the fund was the second most commonly cited factor in choosing a fund (42% of investors), says the Cerulli report. The message is getting out there that we cannot control performance, but we can certainly control costs, says George Papadopoulos, a financial planner in Novi, Mich. a Detroit suburb.

But that leaves plenty of room for misguided approaches to investing. Here are five:

As noted, buying a fund simply because it’s been on a tear is a mistake, because there’s no knowing when that party may end. That said, historical returns can provide valuable insight into the risks you face.

While measuring risk can get complicated, It’s pretty easy to say, ‘That fund lost 50% three years ago. I better be prepared for that or I shouldn’t buy it,’ says Russel Kinnel, director of mutual-fund research at Morningstar Inc.

Morningstar data show that riskier funds lead to mistakes because investors are more likely to bail out of them when prices fall. They get out and miss the rebound, says Mr. Kinnel. Steadier funds tend to lead to better investor experience.

2. Not looking under the hood

Do you know how your dollars are being invested? Too often, investors buy funds without understanding what those funds own and how those holdings may change over time.

This is a particular problem with target-date funds, says Mike Piper, a CPA and host of ObliviousInvestor.com. Target-date-fund managers follow a glide path that outlines how the fund will shift into more conservative investments as the target retirement date nears. But funds with the same target date can have very different glide paths.

Your personal risk tolerance might not be a very good match for what the fund company assumes is a target risk tolerance for someone your age, Mr. Piper says. Look at the fund’s prospectus to make sure you’re not in for a surprise.

Investors sometimes fail to dig deeply enough into bond funds, too, Mr. Piper says. Risk levels vary based in part on the debt issuers’ credit quality and bond maturity dates.

In addition to checking a bond fund’s expense ratio and credit quality, look at average duration for an idea of its sensitivity to changing interest rates. That’s going to give you an idea of how sensitive the price of the fund will be in response to changes in market interest rates, Mr. Piper says. One rule of thumb: For every percentage point increase in interest rates, a bond fund’s value may drop as much as its duration. For example, if a fund’s duration is five years and yields increase two percentage points, the value of the fund could fall by about 10%.

A related mistake: Failing to understand an index fund’s benchmark. That’s especially critical in the fast-growing world of exchange-traded funds. Be careful with funds that track benchmarks with little or no history, and dig deeper to make sure they’re a good fit for you, says Roger Wohlner, a fee-only financial adviser in Arlington Heights, Ill.

Just because it says ‘index’ doesn’t mean it’s a good investment for the average person, Mr. Wohlner says.

3. False diversification

With mutual funds, more isn’t necessarily better, but some investors believe that the more funds they own, the more diversified their portfolio.

Mr. Papadopoulos describes one client whose portfolio included several large-cap growth tech funds. When I asked why, his reply was, ‘Well, I was choosing different funds from different fund companies,’ so he thought they were diversified.

Similarly, investors saving for retirement often tap target-date funds—but then they undermine the idea of these all-in-one retirement vehicles by buying other mutual funds, too. That can lead to a bigger-than-expected exposure to, say, large-cap U.S. stocks or government bonds.

Investors are virtually undoing the entire idea that the professional manager would pick a well-diversified portfolio for you based on your age, Mr. Benartzi says. The mistake, he says, is to think they cannot be in one fund and be diversified.

4. Chasing headlines

Investors often let catastrophes, real and imagined, drive their decisions. The problem is, retail investors are almost inevitably too late.

They think that somehow that macro news they just heard is not priced in, Mr. Kinnel says. But professional investors know that if the unemployment report comes out at 7:30 a.m. it’s priced into the futures market at 7:31 a.m. You’re reacting to past information rather than thinking about buying low and selling high, he says. Instead, stick to your investment plan.

You’re overrating your ability to time the market.

5. Buying on ratings alone

Morningstar’s one- to five-star system is appealing to investors who don’t have time to dive deep into mutual-fund research. But focusing on stars alone is as bad as buying based on what some magazine has deemed, say, the top five funds. In both cases, past performance plays too big a role.

Even Morningstar cautions against going simply by star ratings. Says Mr. Kinnel: There is no single data point that will tell you all you need to know.

Morningstar’s star ratings are useful as one tool in your purchase decision, given that they are a quantitative measure of past risk- and load-adjusted returns going back as far as 10 years.

Morningstar now also offers Analyst Ratings, which attempt to gauge a fund’s potential for future growth by measuring its strategy, management team, fees and other factors.

Whether you use our analyst rating or look at those fundamentals yourself, Mr. Kinnel says, those are among the important things you want to know that may not be fully captured in a star rating or any past-return measure.