Past Performance Is No Guarantee of Future Results
How Chasing High Returns Can Cause Problems for Your Portfolio
Any time you read a mutual fund prospectus or other investment disclosures, you are probably going to come across the oft-repeated phrase, "Past performance is no guarantee of future results." What does it mean and why are so many asset management firms, whether they sponsor index funds or individually managed accounts for affluent investors, insistent upon including it? It goes to the heart of something important if you want to make intelligent decisions and manage your risk: It is the methodology that counts, not the recent scorecard.
Famed hockey player Wayne Gretzky summed up his secret to success when he said, “go where the puck will be, not where it is.” When analyzing a company or mutual fund, many investors would do well to heed the same advice. Instead, they suffer from what is known in the business as “performance chasing.” As soon as they see a hot asset class or sector, they pull their money out of their other investments and pour it into the new object of their affection. The result is much akin to someone chasing lightning – they go where it has struck and then wonder why they continue to compound at lower than average rates of return; a tragedy that is exasperated by frictional expenses.
This isn't a minor thing. One Morningstar research project discovered that during periods when the underlying mutual funds compounded at 9%, 10%, 11%, the actual investors in those funds only made 2%, 3%, and 4%, because they were constantly buying and selling at precisely the wrong times, allowing their emotions to control them rather than taking a long-term view of investing.
What Is Past Performance Good For If It Can't Predict Future Returns?
As the late Benjamin Graham, father of value investing, pointed out, past performance is useful in calculating the value of a stock, bond, mutual fund, or another asset only so far as it is indicative of what is to come in the future as it pertains to owner earnings or interest coverage ratios.
For example, it's useful to know how the oil majors have historically done during periods of collapsing crude prices because that can give some insight into the way the business works. You can get into the nuts and bolts and see what is the same, what is different, and how that is going to influence cash flows. It's nice to be aware that the p/e ratio on oil stocks is going to look lowest when they are most expensive due to a phenomenon known as a value trap. That has a certain utility.
Back in the early 2000's, black gold had been trading at $10 a barrel and very few analysts foresaw the end of the energy sector's woes. As of 2016, the industry is in the opposite situation. Oil prices have collapsed, energy analysts are saying it could last until the end of the decade or longer, and the stocks in the sector have been hit hard following years of extraordinary prosperity. This is normal for the oil industry, but investors often don't behave like it.
Questions to Help You Avoid Chasing Past Performance
How can an investor protect against jumping into a hot sector, fund, stock, or asset class, seduced solely by good recent performance? Here are a few questions you may want to ask yourself that might be able to offer added protection against overly emotional decisions:
- What makes me think the earnings of this company will be materially higher in the future than they are at the present time?
- What are the risks to my hypothesis of higher earnings? How likely is it that these theoretical risks will become actual realities?
- What were the original causes of the company’s under-performance or over-performance? If it was in any way linked to aggressive accounting, what makes you sure that the situation has been permanently resolved and integrity restored to the firm? If it was an industry-specific problem, what makes you think that the economics going forward will be different? (Industry changes are fairly rare, though they do happen -- it isn't an accident that the best stocks to own over the past few generations have been concentrated disproportionately in a handful of industries.) A temporary supply and demand situation? Lower input costs?
- Has this particular sector, industry, or stock experienced a rapid increase in price in recent history? Knowing the principle that price is paramount, does this still make the investment attractive? Have the prospects for better earnings already been priced into the security when looking at traditional metrics such as the dividend-adjusted PEG ratio?
- Am I making this acquisition or disposition based upon valuation, systematic purchases, or market timing?
- If there has been a significant deviation from the mean in any major sense - valuation levels, earnings levels, dividend yields, or whatever -- what makes me think there won't be a reversion to the mean? How do I know that this truly is the "new normal"? How do I know I'm looking at an automobile company following the decline of horse and buggy manufacturers and not a widget factory enjoying record high profitability during boom years that will decline, like normal, during recessions?
In other words, the secret behind mistaking past performance for future results is knowing that it mostly comes down to underlying cash flows. If you understand how the cash flows are generated, what is generating them, how quickly they are likely to grow in the future, and how much tangible equity it takes to generate them, you can work out the rest more often than not.