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 any kind of investment-related disclosure, you are probably going to come across a phrase that goes something like this: "Past success does not guarantee future performance." You'll see this disclaimer tacked onto everything from index funds to individually managed accounts for affluent investors.
So why is it there, and what exactly does it mean? It goes to the heart of a crucial component in making intelligent decisions and managing your risk: it is the methodology that counts, not the recent scorecard.
Not Just Good Advice, It's the Law
Asset management firms are required by the Securities and Exchange Commission to say that past performance is no guarantee of future results. That's in part because many of them use past performance as part of their advertising campaigns. Past performance can be a helpful metric when choosing investments, but it shouldn't be the only aspect an investor considers. Asset management firms are required to remind you that all investments carry some risk, even the relatively safer or more successful ones.
Furthermore, the way an asset management firm calculates its past performance can be misleading. One Morningstar research project discovered that, during periods when the underlying mutual funds compounded at 9%, 10%, and 11%, the actual investors in those funds only made 2%, 3%, and 4%, respectively.
That discrepancy stems from investor behavior. As opposed to the mutual fund, which held a relatively steady portfolio, investors in the study were constantly buying and selling. More often than not, the investors were trading at precisely the wrong times, allowing their emotions to influence their decisions. They would buy more during rallies and hold (or worse, sell) during slumps. In terms of consequences for wealth building, that is a catastrophic strategy, especially once you've factored in inflation.
Hockey superstar Wayne Gretzky summed up his secret to success as a recognition that a good player must, “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.
Examine Past Performance Over A Long Period
Past performance can be helpful when analyzing an investment, but it's important to look at a long time horizon. If a stock goes up 15% in one year, that alone doesn't tell you much about whether it is a good investment now, or whether it will be a good investment in the future. However, if a stock has shown average annual returns of 9% for more than 40 years, that's a positive sign, especially if you have a long investment time horizon. Nothing is guaranteed, but long-term past performance can certainly offer insight into the potential for a stock's growth.
When analyzing past returns, it's best to generally ignore returns from the past few years and focus on 10-year returns—or longer. Those longer returns are more indicative of the stability and strength of what you are investing in.
Questions to Help You Avoid Chasing Past Performance
How can an investor protect against jumping into a hot sector, fund, stock, or asset class? If you're considering an investment, pause and ask yourself a few questions. Taking the time to answer these questions could help protect yourself from overly emotional decisions:
- What makes me think the earnings of this company will be materially higher in the future than they are now? If there's little-to-no growth opportunity, why do I need to invest right now?
- If I believe the company will grow, what are the risks to my hypothesis of higher earnings? How likely is it that these theoretical risks will become actual realities? What's a worst-case scenario look like for this investment?
- Why did a company under-perform or over-perform in recent years?
- Has this particular sector, industry, or stock experienced a rapid increase in price in recent history? If so, why do I think it will continue to rapidly grow?
- Am I buying or selling based on valuation, systematic purchases, or market timing?
- If there has been a significant deviation from the mean, in any major sense, what makes me think it won't revert back? How do I know that this truly is the "new normal?"