Past Investment Performance Matters…Does it Really?

Transcript

One of, if not the, most common disclosures you see when it comes to investing is “past performance is no guarantee of future results.” This is the first thing every compliance officer slaps on a marketing piece that shows historical investment performance. However, when I was working as a financial advisor, meeting with prospective clients, it was almost always one of the first questions someone would ask when we started discussing the specific investments we were recommending.

Typically, they would patiently listen to my explanation of what we were proposing and then follow it up with something like, “How did it do last year?” One of my favorite responses to this question was simply, “Does it matter?” This got me some snarky looks over the years, since most people think it is a really important question. Well, stay tuned if you want to become educated on why this question is probably not as helpful as you might think it is.

Welcome to the first season of Invested Poorly: Sad Tales of FInancial Fails, a short-form podcast designed to help everyday investors make wiser investment decisions by learning what NOT to do with their money. Host Jeff Harrell shares timeless stories from his former life as a financial advisor, about the poor—and irrational—choices he witnessed investors make that disrupted their journey to financial independence, or FI. Your ability to recognize, and avoid, similar mistakes could make all the difference for you along your path to reach FI.

Check out the “Introduction” episode for more background on Jeff, why he created this podcast, and how it can guide you to becoming the hero of your own investing story. Now, on with show.

I often used to joke that investors typically like to receive one of three investment returns every calendar year. Either the return of the stock market, or at least a 5-6% rate of return, or whatever their neighbor down the street said they made, whichever return was the highest. Now, I hate to burst your bubble. These are totally unrealistic expectations, but unfortunately, this is how a lot of investors think, which is why performance was always one of the most difficult topics to discuss when I was an advisor. The reason is because while evaluating past performance is relatively straight forward, using it to forecast future returns is quite frankly useless.

My two decades of experience in the industry was more than enough evidence to convince me of this, but if you need more proof, I encourage you to take my inquisitive little nephew’s advice and “search it up” using phrases like “past performance stock market studies.”  You will find numerous research articles that come to the same conclusion: “past performance is no guarantee of future results.” So I guess those compliance officers can all keep their jobs.

But here is the really sad news, despite the overwhelming evidence that past performance is a poor predictor of future results, many investors can’t help but be mesmerized by it. This is because… now pay attention, don’t doze off during this segment because I’m about to say something profound that I don’t want you to miss… investors are notorious for buying what they “wished” they’d owned. I saw this happen all the time.

One particular instance I remember vividly was when a client called up asking for my thoughts on a mutual fund he was considering investing in. It had a spectacular 3- and 5-year track record, handily outperforming most of the funds that invested in a similar strategy. After looking at the performance, I asked him a couple of questions about the fund, such as how long has the manager been there, what’s their investment strategy, what type of fees do they charge, you know, things like that.

Honestly, it wasn’t surprising at all that he didn’t know the answer to any of these questions. All he said was, look at the returns. I told him they were very impressive, but I then asked if he had looked at what the returns were like five years ago. I don’t think he really understood the question until I explained what I was going after. What I was trying to find out was, if five years ago, the 3- and 5-year returns looked as good then, as they do now.

Of course he didn’t know the answer, so I looked it up. Much to his surprise, I showed him the trailing 3- and 5-year returns, five years ago, were well below average at that time. It was kind of a gotcha moment, which illustrates my point that investors love buying what they “wished” they’d owned.

What makes this story so important for investors to understand is that investment companies know how important recent performance is to attracting assets, which allows them to prey on investors by using all kinds of shady tactics. One of the most extreme that I ever saw began with a phone call from one of our fund managers. They started off with the normal pleasantries, but then quickly got excited to let me know they had sold their fund to another investment firm.

So, after that call ended, I set up a meeting with the new fund manager to learn more about the fund it was being merged into. Not surprisingly, it had a phenomenal track record over the past five years, and as you can imagine they were extremely proud of it. They had all kinds of marketing literature highlighting its returns and investment strategy. Everything looked impressive on the surface, but lurking behind the scenes was something that might raise a few eyebrows.

The first thing I did prior to my meeting was go to their website to learn a little more about the company. The company had only been in existence for a little over five years and I was able to determine they had four different investment strategies. The one that our fund was being merged into was the focus of their website. It was being promoted every way you could possibly imagine. The other three strategies, well, let’s just say there wasn’t much marketing on the website for them. They had very little assets and their trailing returns left much to be desired.

I hope you can see where this is going because it became obvious to me what this company had done. Essentially, they started an investment firm five years ago with four distinct investment strategies. They didn’t grow much over those first couple years while they established a track record for each strategy. Then after five years they all had 5-year track records and they used the one with the best track record to attract assets. I remember questioning the fund representative on this. Needless to say, he got defensive pretty quickly, and the call ended with us deciding to pull our assets from the fund.

So what do you think? Was I right or wrong? I’ll leave it up to you to decide. For me, it is just another reminder that “past performance is no guarantee of future results.”

I sure hope you enjoyed this episode of Invested Poorly and will be able to take something from it to improve your decision making as you navigate the twists and turns of your personal investing adventure. Be sure to check out my website at AreYouFI.com (that’s A R E Y O U F I dot com) where you can find resources and show notes with the charts and graphs I mention during the episodes. These are like little treasure maps that can help you choose more wisely along your quest to reach FI, or financial independence.

Never forget, in the short-term the stock market is unpredictable, and as my mischievous little nephew likes to say, “things just happen”! So focus on the long-term, by controlling your emotions, simplify your investments, and always… ignore the noise.

I’m your host, Jeff Harrell.  Thanks for listening.

Invested Poorly: Sad Tales of FInancial Fails was created for informational purposes only and should not be relied on for specific tax, legal, or investment advice. You should consider consulting a qualified professional to review your situation before engaging in any transactions. Investing involves risk, including loss of principal and past performance is no guarantee of future results. 

This podcast was produced by Ted Cragg. Learn more about creating podcast mini-series like this by visiting QuickEditPodcasts.com.