Beware the Temptation of Past Performance
Whenever a mutual fund advertises performance, the Securities and Exchange Commission requires that it include the disclaimer that "past performance does not guarantee future results."
A study by researchers at Arizona State University and Wake Forest Law School suggests that this warning is not enough. They recommend something a bit stronger: "Do not expect the fund's quoted past performance to continue in the future. Studies show that mutual funds that have outperformed their peers in the past generally do not outperform them in the future. Strong past performance is often a matter of chance."
Despite the warning from the SEC and pretty conclusive evidence that past performance has very little predictive value, most of us still use performance as a significant factor in choosing our investments.
This is one of those times in investing where our experience in almost every other area of life works against us. If you're going to hire contractors to remodel your house, one of the first things you do is look at other houses they've built. It seems reasonable to expect that the work they do on your house will be at least as good, if not better.
When it comes to mutual funds, however, the past has almost no predictive value. People have spent years looking for a way to identify mutual funds that will do well going forward. They have looked at almost every factor you can think of: education, experience, hair color, and, of course, past performance.
The only factor anyone has found with any predictive value was the internal costs of the fund: the higher the costs, the worse the performance. This is a case where you often get what you do not pay for.
Despite all the evidence to the contrary, we still scour the annual lists of "10 Hot Funds to Own Now," which are often based on past performance, looking for a place to put our life savings. We still look in the rearview mirror.
Think about the last time you made an investment decision. Did you look to the past for some prediction of the future? After all, how much sense would it make to invest in a fund that performed poorly?
But finding the next Peter Lynch is an almost impossible task. Focus instead on finding a low-cost investment that you can stick with over the long haul.
A version of this post appeared previously at The New York Times.
Carl Richards is a financial planner and the director of investor education for the BAM ALLIANCE, a community of more than 130 independent wealth management firms throughout the United States. Visit Behavior Gap for more of Carl's sketches and writings.
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