Past performance is no guarantee of future results. That’s an often repeated phrase in investing. Investors, however, seem to be of a different mind. In a TIAA-CREF survey, 36 percent of respondents pegged one-year performance as the most important indicator of an investment’s return. Forty-seven percent of investors said they’d chosen mutual funds based on the preceding year’s performance, without looking at historical returns.
Basing your investment strategy on past performance (especially recent performance) can easily backfire. “Annualized rates of return mask a lot of the variability that investments experience,” says Eric Meermann, certified financial planner and vice president of Palisades Hudson Financial Group in Stamford, Connecticut. “Assets that have performed well may not continue to do so,” creating misleading impressions for investors.
[See: 10 Long-Term Investing Strategies That Work.]
In fact, assets that have performed the best in recent years may be the ones poised for a downturn, Meermann says. They may be so overvalued that they’ve become riskier choices.
Relying on recency bias to guide investment decisions can be particularly dangerous when the market is on an upswing, says Colin Richards, founder and president of Lord and Richards in Highlands Ranch, Colorado. Investors move into the market hoping to capitalize on rising prices, even when signs may be pointing to an impending correction. That behavior, Richards says, can lead investors down a precarious path.
Past performance is just one piece of the puzzle when evaluating investments. Understanding how performance fits in with your overall investing strategy — and what else should be considered — can keep you from developing tunnel vision.
It’s future performance that counts. If you’re investing long term, your perspective should reflect that. Look ahead, rather than backward, says Patrick McDowell, a certified financial planner and accredited investment fiduciary with Arbor Wealth Management in Miramar Beach, Florida. “Most financial reports represent the past, but almost all of the value of a business is in the future.”
The difficult part of investing, he says, is trying to bridge the gap between what’s happened and what lies ahead. That entails asking the right questions. Investors often aim for the same rate of return that an investment has delivered in the past. Instead they should consider why the company earned such high returns in the past, and how likely it is that those same factors will continue enabling the business to outperform.
Consider also how the state of the market is likely to shift over time. “If an investor is selecting a fund or manager, the key to looking at returns is understanding how that fund will behave in different market environments,” says Rusty Vanneman, chief investment officer at CLS Investments in Omaha, Nebraska. The best investments are the ones investors understand so that there are no surprises.
Avoiding the past-performance trap can help you evaluate fund managers better. The goal should be choosing a manager that you can have confidence in long term, rather than basing the decision on prior returns. No manager succeeds in all environments, Vanneman says, and switching managers or funds based on recent performance is the type of self-destructive behavior that can torpedo your returns.
[See: The Fastest Ways to Lose Money in the Stock Market.]
Expectations should be tempered with a hearty dose of reality. A common target for many investors is to meet or beat the market. While that may be possible for a while, it’s not always sustainable.
Meermann points to the Standard & Poor’s 500 index as an example of how investor expectations don’t always match reality. The statistical expected return of the S&P 500 is about 11 percent, he says, but annual returns since 1928 have ranged between -44 percent and 53 percent. That wide gap illustrates the inconsistency in stocks and their variability over shorter periods. To ride out periods of volatility, you’ll need to manage your expectations. Otherwise, basing decisions on recent performance could prompt you to buy and sell at inopportune times.
You’re better off tempering your expectations of past results with a rules-based approach that includes your risk tolerance, Richards says. That’s particularly true for investors who are living off their portfolios and trying to maintain their investments while still pursuing growth. Taking on too much risk to chase a benchmark can expose your portfolio to larger losses, which are then compounded when monthly income is drawn off your nest egg. “Most investors are accustomed to the fact that with higher potential returns come higher risks,” Richards says. They’re often surprised to find that prioritizing protection against losses over realizing gains can have lasting effects on portfolio growth over time.
Diversification is your strongest line of defense against market volatility. As you mold your portfolio, it helps to think of it as a group effort. Just like a football team, which assigns faster players to do the running and stronger players for blocking and catching, your portfolio “needs to have different asset classes and securities that play different roles,” McDowell says. “You don’t want everything producing the same level of returns.” Different investments in a portfolio should be working in concert with one another, not marching in lockstep.
Diversification can help minimize any negative consequences of chasing past performance with a specific investment. Tracie McMillion, Wells Fargo Investment Institute’s head of global asset allocation in Winston-Salem, North Carolina, analyzed a hypothetical portfolio that invested 100 percent in the prior year’s top-returning asset class from 2002 to 2016. The portfolio produced an average return of 3.6 percent and an average standard deviation of 19.3 percent.
When that hypothetical portfolio was compared to a globally diversified portfolio, the fallacy of relying on past performance became clear. The diversified portfolio generated a 7.3 percent return, with a standard deviation of 8.6 percent. In other words, diversification resulted in twice the returns with half the volatility.
“One of the biggest risks many investors face is not a total loss of their portfolio’s value, but failing to meet their financial goals because they take an inappropriate level of risk,” McMillion says. For some investors, it’s too much risk; for others, too little. Creating a comprehensive picture that includes the risks for volatility, liquidity, leverage and market-affecting events can help you determine your asset allocation without being unduly swayed by performance.
[See: 13 Ways to Take the Emotions Out of Investing.]
Once you find the right balance between risk and performance, stay the course. “When seeking long-term capital appreciation, you should expect volatility,” Meermann says, but don’t be tempted to deviate from your original investment strategy.
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Don’t Fall Into the Past-Performance Trap originally appeared on usnews.com
