Judging an investment based on recent past performance could also turn out to be a mistake
Have you ever waited a long time to watch a movie directed by a renowned filmmaker who had clinched many Oscar and Emmy awards in the past, only to be disappointed by its lackluster script after you have watched it?
Just as how we cannot judge a movie based on the past achievements of a movie director, judging an investment based on recent past performance could also turn out to be a mistake.
Research shows that past performance offers little insight into a fund’s future returns as most US-domiciled equity and fixed-income funds in the top quartile of previous five-year returns did not maintain a top-quartile ranking in the following five years.
Source: Dimensional, Morningstar.
History can serve as a good guide to form evidence-based investment principles such the markets will always recover the in long run; stocks will generally outperform bonds; and how even within stocks, higher expected returns can come from stocks of smaller companies, that are cheaper relative to its assets, and have positive cash flows.
However, looking at only the past performance of individual funds to decide which one to invest in is similar to driving forward while looking backward. Instead, rely on the market principles based on evidence, not what the market did or will do in the short term, to help you make sensible investment decisions.
This is likened to using real-time traffic information to get a more accurate estimation of the time it takes to get to another place, compared to past information found on the Internet.
This series is adapted from the book, 27 Principles Every Investor Should Know, written by Steven J. Atkinson. Read the rest of the principles:
- Investing Principle #1: Always Start With A Plan
- Investing Principle #2: Start Investing As Early As You Can
- Investing Principle #3: Invest For The Long Term
- Investing Principle #4: Investing Is Hard – Get Help From A Trusted Advisor
- Investing Principle #5: Know the Difference between Advisers and Salespeople
- Investing Principle #6: Put Science and Academic Research on Your Side
- Investing Principle #7: Don’t Try To Pick Individual Stocks
- Investing Principle #8 Don’t Try to Predict Markets
- Investing Principle #9 Invests as if Markets are Efficient
- Investing Principle #10: If You Can’t Beat the Market, Own the Market
Author: MoneyOwl’s Solutions Team