Making decisions based on past performance works...except when it doesn't
Shortly after the 2018 Winter Olympics closing ceremony, I started thinking ahead to the 2022 Winter Olympics.
Will Canada repeat its record medal haul? Will Russia dominate figure skating again? Will Norway and Germany win the most medals again? My questions reflected a deep-rooted acceptance that past performance is key to forecasting future events. Consider this: Germany has placed first or second in the medal count in seven of the eight Winter Olympics held since 1992.
Drawing on past performance to make inferences about the Olympic medal count is an approach you can apply to other situations, like picking a restaurant. (Why risk eating at a bad restaurant when diners' recommendations and ratings are a click or touch away online?)
So, it's true that basing decisions on past performance works in some situations. But that doesn't make prognostication a reliable strategy for choosing investments.
Why don't all top-performing investments continue to outperform? It's complicated.
Projecting a country's future medal count in the Olympics is based on a finite number of related factors, including athletes' collective skill level and their previous performance. But the factors that affect investment outcomes—such as market volatility, political and economic climate, and expectations around company or sector performance—are cyclical and random.1
When you're selecting mutual funds, you have easy access to rankings, ratings and historical returns. However, research shows that top-performing funds rarely make it to the medal podium twice. Funds that are winners one year are often losers the next, and vice versa. Simply put, an investment's past performance isn't a reliable indication of future performance.
Break the cycle of poor investment decisions
We're creatures of habit. It's human nature to rely on what we've learned in the past. We won't (knowingly) touch a hot stove twice, for example.
Old habits die hard, though. While you might not be able to eliminate the influence of past performance when selecting your investments, you can take measured steps to achieve a more balanced approach.
Be aware of the situation. We make decisions based on our experiences every day. For example, if you've had several positive experiences buying lunch from the corner shop near your office, you probably won't be disappointed if you go there again today. The factors that affect your experience—food selection, quality and value—are consistent. But investing is different.
Market performance and other factors are unpredictable at best (and erratic at worst), so it's unproductive to rely on a "past performance predicts future results" mentality. In fact, research shows that historical investment performance appears retrospectively more random than predictive.1
Control what you can. Focus your energy on costs and asset allocation. There are predictable benefits to choosing low-cost investments and maintaining an appropriate asset allocation. Low-cost investments can help you keep more of your returns, and a suitable asset allocation can help you manage risk. Actually, for investors with a well-diversified portfolio, your asset allocation affects your returns more than any other choice you make.2
On the flip side, there are no predictable benefits to making investment decisions based on past performance.
Be disciplined. If you have a simple financial plan with clear goals and an appropriate asset allocation, have confidence in your portfolio during good times and bad. And once you create a financial plan, it's easy to be a disciplined investor—all you have to do is stick to your plan.
Find a good coach, if needed
Coaches can be the key to unlocking an athlete's potential. A good coach teaches self-awareness, control and discipline—qualities that can lead to consistently better performance. If you need help making the best possible investment decisions, consider partnering with your own "coach"—a financial advisor who can help you get on track and maintain momentum until you reach the finish line.
Published MAy 30, 2018
Commentary buy Shyam Yekanath