When investing in mutual funds, all too many amateur and professional investors and advisors try to take the easy way out. Instead of looking at the hard stuff — company fundamentals, industry trends, business plans and so on — they try to profit with a strategy called “momentum investing.”

You might think of momentum investing as a mutation of growth-stock investing. Traditionally, growth-stock investors zero in on companies that have reported several years of growth and seem likely to keep on growing. Whether investing in mutual funds or stocks, growth investors tend to focus on investments that they plan to hold for years.

Momentum investors also focus on growth stocks and funds — but with a shorter-term focus. They want to hold these investments only while prices are rising. They don’t mind paying a high price, because they plan to sell quickly if the rise begins to falter.

A momentum approach will eventually cost you money when investing in mutual funds

Momentum investors are keen on the so-called “positive earnings surprise,” when a company outdoes brokers’ earnings estimates. They view a “negative earnings surprise” — lower-than-expected earnings — as a sell signal. They use a variety of formulas to make buy and sell decisions, but all come down to “buy on strength and sell on weakness.” So they tend to pile into the same stocks all at once, and the gains that follow are something of a self-fulfilling prophecy.

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One key problem is that when the stock’s rise falters, momentum investors try to get out as a group, but there are never enough buyers. This leads to violent price fluctuations for these stocks, or mutual funds that hold them. When you hear that a stock reported a 10% earnings gain and its shares dropped 25% to 50%, it often means that the momentum investors who owned it were hoping for, say, a 12% earnings gain.

“Mutual fund leapfrog” is a risky approach to investing in mutual funds

It’s natural to be tempted to try a momentum investing approach by leapfrogging from one fund to another, and routinely switching out of the laggards in your mutual fund portfolio and into funds with better performance. But basing investment decisions on performance alone is bound to cost you money sooner or later.

That’s because it raises your risk of investing in a fund that owes its performance to having gambled and won. When a gambler’s luck turns sour, he may give back all of his winnings and more besides.

Avoid the opposite but equally risky mistake

Some investors recognize the error of momentum investing in mutual funds. They aim to profit by doing the reverse. When a fund they own goes up “too far and too fast,” as the saying goes, they sell and switch the money into a lagging fund, on the theory that funds alternate between leading and lagging. But that puts you at risk of selling your best funds way too early. It also puts you at risk of buying funds that own a lot of bad stocks. These funds may go much, much lower.

Regardless of whether you routinely sell laggards to buy leaders, or sell leaders to buy laggards, you are making the same mistake: you are still basing your investment decisions purely on investment pricing, and ignoring investment quality. That’s bound to hurt your results. There’s a big random element in investment pricing. In contrast, investment quality is the key to long-term safety and profit.

We continue to believe the best approach to long-term profit in investing in mutual funds is to stick with well-managed funds that seek value and investment quality in their investment choices. (This is the approach we employ in our special report, “Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds”). Top-quality funds like these may lag for a time, but they inevitably catch up.