Is past performance important for investors?
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How should you choose your investments? When building a portfolio, many investors focus on past performance – e.g. the price growth of a fund over the last 10 years – to try and identify “winners”. Yet, there are great limitations to this approach.
In this article, our Grantham financial advisers explain why past performance – whilst an important consideration when choosing investments – cannot be relied on to build a robust portfolio. Instead, investors need to consider a wider range of factors, which we elaborate on below.
We hope these insights are helpful to you. To discuss your own family financial plan with us, please get in touch to arrange a no-obligation financial consultation, at our expense:
01476 855 585
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Why do investors look at past performance?
Naturally, humans are curious about the future. What will the weather be like tomorrow? Will my football team win the cup? Will shares go up or down this year? We reach out for any possible signs that may aid our predictions so we can plan accordingly.
The past shows us how an investment has historically behaved. This provides psychological comfort, as an investor might assume that this behaviour will continue into the future. Yet, as many investment disclaimers (rightly) point out, past performance does not guarantee future results. What happened in the past may not happen again.
Why can investors not rely on the past?
Market conditions, economic factors and other variables can change, impacting investment outcomes. For instance, during the Great Depression of the 1930s, the US government allowed hundreds of banks to fail, the dollar was pegged to the gold standard and the economy was highly “protectionist” (blocking imports to protect domestic jobs/industry). These factors all contributed to a downward spiral in the stock market.
Contrast this picture with the 2008-9 Financial Crisis. In the US, Lehman Brothers was sacrificed on the altar so that the rest of the banking system could be bailed out. The dollar was now free-floating, and the economy was highly “open” following decades of trade liberalisation around the world. Interest rates hit nearly 0% to try and stimulate aggregate demand – accompanied by successive rounds of “quantitative easing”.
Some economists argue that these measures in the late 2000s – and the different macroeconomic context – helped the US economy bounce back from the recession much faster (after 18 months) and recover the stock market faster (about 5 years) than the 1930s Great Depression. The latter took around 25 years to recover.
Looking at these two pictures, which policies or economic variables were most important in determining how various investments performed? There is no consensus. Also, within these bigger pictures were thousands of “economic agents” – politicians, institutional investors and company directors – who would be different even if exactly the same “macro conditions” were replicated in the future.
In short, the past cannot be fully understood or repeated. Therefore, investors cannot fully rely on it to judge what will happen.
What can investors do instead?
Another danger of relying on the past is that an investor may pick “winners” after they have already crossed the finishing line. In other words, a particular company may have already reached most of its growth potential by the time an investor notices it.
Perhaps, at this point, the price is overvalued and other investors start selling to crystallise their gains – pushing down the price just after the new investor bought a stake. Very quickly, the “winner” becomes a “loser” in this investor’s eyes!
The past can contain helpful information, but investors should also consider it alongside other factors such as fundamental analysis, market trends and risk management strategies. For instance, when considering a specific investment fund for your portfolio, what are its individual holdings? What kind of growth potential do they have? What kind of “liquidity risk” might be involved (i.e. how easily could you get your money out if you wanted to sell)?
Another important principle to consider is diversification. By spreading out your investments, you are acknowledging the realistic outcome that some of them may not perform as you hope and expect. Here, your other investments can support and “buttress” your portfolio against excessive underperformance (e.g. in a “down market”).
A wise investor focuses on what they can control rather than trying to “outguess” the markets. This involves keeping powerful emotions in check, such as avoiding the temptation to “follow the herd” when other investors flock to a “hot stock”. It means picking a strategy and risk tolerance which suits your needs and sticking to the long-term plan agreed with your financial adviser. Finally, make sure that your portfolio is wisely structured (e.g. for tax), investment fees are kept competitive and global diversification is built into your asset allocation. A professional can help you navigate these various factors with confidence.
Invitation
If you are interested in discussing your own financial plan or investment strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:
01476 855 585
info@casfin.co.uk
