Yeah, I know you’ve read the standard disclaimer everywhere ”Past performance is not a guarantee of future results”, which is required by the SEC. I also know that you instinctively understand it and ignore it at the same time. After all, why wouldn’t you?
Past Performance in Our Daily Lives
We use “past performance” in almost every other aspect of our lives, like:
- Amazon.com reviews: Who doesn’t devour these before purchase? I’ve discarded the thought of buying a product that looked great until I saw that it had only a 3-star rating? Buying anything below a 4-star minimum is just beneath my hard-earned dollars. This, of course, can make or break a product, but there are comfort and surety in walking in the shoes of those who have gone before us.
- Yelp.com ratings: With the occasional travel, whether for business or leisure, a lot of us have got the Yelp app. Pop it open, enter a cuisine of your choice (if you care) and pick a restaurant close by that’s got rave reviews. You will rarely be disappointed. Now, I could easily have picked the Michelin Guide but you know what I mean. Also, I think we’re more “millionaire next door” than anything else. I do want to eat in a Michelin-rated restaurant at some point, but I digress.
- Need a good mechanic or an appliance repair guy – you know where to go. Once you find them, you invariably go back to them even if they’re not the cheapest option because you want good quality at a reasonable price.
- Need a new washing machine or a reliable car – Consumer Reports is your best bet!
So if the same thought process works for most of our other purchases throughout our lives, why is past performance not a guarantee of future results?
Why Is Investing Different?
Investing is different, and for multiple reasons:
Investment and Economic forecasting are well, difficult to say the least. There are a lot of variables, all of which are continuously changing. To add to that, the expectations of the folks participating in the market change the outcome.
- Strong performers tend to have money chase after them, leading to higher valuations and making it more difficult to continue to be a strong performer. Historical data supports that. The image below is sourced from an MFS report where they make the case for fixed income diversification. However, the performance of various asset class from 1997-2016 tells a sordid story. You cannot predict, period.
- Human behavior is irrational. We are emotional. We pull money out of investments that haven’t done so well and put it into the next “hot” investment. Bitcoin, anyone? This results in selling at lows and buying at highs and paying transaction costs along the way.
- Even though there is an abundance of historical performance data, giving rise to the likes of Morningstar and Lipper ratings, the link between past and future performance has been scientifically proven to be very weak. Vanguard calculated based on Morningstar data that only 16.2% of funds remained in the top quintile 5 years later.
What Do We Do Instead?
This part is simple to understand but takes some effort to follow.
The first step is admitting that the way we make decisions about the rest of our purchases cannot be applied to investing. Be aware.
Second, educate yourself about the various broad market asset classes and develop an asset allocation. Start small and simple, and as you learn and get more confident, adjust your allocation accordingly.
Third, develop an investment policy statement to guide through the tulip manias and cryptocurrency frenzies. It will be based on goals and long-term portfolio needs, rather than recent performance. Do not ignore fees.
Don’t forget to put some real money aside for “play”. This should only be 5% (or less) of your portfolio but gives you the flexibility to invest in whatever strikes your fancy. I believe it functions the same as a “cheat” day on that latest diet you’re on.