Past performance does not guarantee future results. It’s a standard disclosure you’ve probably seen or heard in investment-related marketing materials a thousand times. Yet, for some reason, this warning doesn’t seem to stop investors (and many financial advisors) from making decisions based on past performance.
Most investors are what I call “performance chasers.” When they’re choosing investments for their portfolio, they look at the last 5, 10, or 15 years of performance and choose the best performers. If you need evidence of this, all you have to do is look at cash flows into and out of mutual funds. If you analyze the cash flows of the most successful mutual funds, you will see that money flooded into them after several years of strong performance.
This seems like a sensible strategy. After all, if an investment has performed well for multiple years, that surely must be some indication that it’s a good investment for the future, right? Unfortunately, it’s not.
The research team at Dimensional Fund Advisors tested this strategy by sorting funds based on their performance over the prior 3 years and tracking them over the next 3 years. As you can see in the results below, if you picked one of the funds that were in the top 25% over the prior 3 years, there was a 3 out of 4 chance you ended up in the bottom 75% over the next 3 years. Not very promising odds for performance chasers.
This doesn’t just apply to individual mutual funds - it applies to asset classes too. An asset class is a group of investments that have similar characteristics. For example, small companies in the US would be considered an asset class.
The chart below shows the relative performance for various asset classes each year from 2003 to 2017. If it looks completely random to you, that’s exactly the point. You never know which asset classes will do well in a given year. It’s also not uncommon for an asset class to be the best performer one year and the worst performer the next (check out US real estate between 2006 - 2007).
If we can’t rely on past performance to tell us how to invest, what are we as investors to do?
Instead of chasing after past performance, I suggest you take a more disciplined approach to investing. Choose a ratio of stocks to bonds that is aligned with your financial goals and risk tolerance. Diversify across many different asset classes to ensure you’re positioned to capture investment returns wherever they occur. Choose investments with low costs and low turnover to keep more money in your pocket. Most importantly, maintain the discipline to stick with your portfolio no matter what.
This isn’t the most thrilling approach to investing. In fact, it guarantees you’ll never be the best performer in any given year. But, you’ll be setting yourself up for a successful lifetime investment experience and you’ll avoid the inevitable disappointment of performance chasing.
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