Giving Weight to Past Performance. . . Why Do We Do It?
Retraining your brain is a pretty difficult thing to do, but if you’re going to succeed with your investment strategies, that’s exactly what has to happen.
As David Swensen warned in his August 2011 article in the New York Times against listening to investment advertisements that tout past performance, “Mutual fund companies, retail brokers, and financial advisors aggressively market funds awarded four and five stars by Morningstar…but the rating system merely identifies funds that performed well in the past; it provides no help in finding future winners. Nevertheless, investors respond to industry come-ons and load up n the most “stellar” offers.”
With all the proof that past performance should not be one of the factors taken into consideration when investing, along with all of the disclaimers and warnings that are now included in the fine print of the mutual fund advertisements, why is there still a steady stream of individuals handing their nest egg over to for-profit mutual fund managers? I’m glad you asked. I’m going to tell you why.
Past Performance Counts in Life…Not in Investing
The reason why knowledgeable, intelligent investors return to the game of chasing past performance again and again is because our brains are wired that way.
We judge everything in life on past performance. The very reason why David Swensen is able to write his opinion editorial for the New York Times and the reason his opinion is respected is due to his past performance, or what he has previously accomplished.
As individuals, we judge track records every minute of every day. In fact, looking at the track record of anything is the most intuitive evaluation method we have. To ignore past performance neither comes naturally to us, nor is it logical.
Let’s say you are about to purchase a new car for your college bound daughter. What’s the first thing you are going to look for? Safety features. You’ll most likely check Consumer Reports to find crash test results and compare side by side performance results. What kind of performance? PAST PERFORMANCE.
You have a new employee and although he is an excellent communicator, bright, insightful and proactive in his work, he has been more than 15 minutes late for work on three separate occasions this week. Now, when 9 am arrives, you find yourself walking past his office to make sure he’s at his desk. You don’t do this for anyone else on your staff, just this one employee. What are your actions based on? PAST PERFORMANCE.
Your relatives are in town for the first time and you’ve decided to show them the local sights. After a few stops, the conversation turns toward dinner. What’s the best place to get a mouth watering steak in this town? They name a couple of the restaurants ahead and ask your opinion. The answers you provide are based on what? PAST PERFORMANCE.
There’s no way to get around it or out of it. We make decisions based on past performance every day. Why? Because we are humans, we’ve experienced things. We like to calculate our odds and make rational decisions. If we received a subpar meal at the local steak house four out of four times in a row, we’d be foolish to think, “Well, past performance doesn’t predict future results.” Of course it does! Unless the restaurant is taken over by new management or announces a menu change, a re-grand opening, or a change in their executive chef, chances are very high that you will once again receive a subpar meal if you visit this restaurant for a fifth time. Reputations are born based on past performance.
On the other hand, if the restaurant is particularly wonderful, you’ll most likely have a high degree of confidence taking your guests there for a special meal. Again, past performance.
The Games of Mutual Fund Marketing
The marketers who churn out the million dollar advertising campaigns for mutual fund companies are well aware of the way the general public thinks. Large corporations don’t just hire skilled graphic designers and copywriters for their campaigns. They hire marketing psychologists. These psychologists are well aware of the fact that judging on past performance is ingrained in our psyche. It makes sense to us. Hearing that a fund has performed well for the past three years gives investors that warm, fuzzy, secure feeling that they are looking for. It’s a shame that it’s all a smokescreen. But, year after year, campaign after campaign, the crowds continue to sign on the dotted line, saying yes to the high fees and poor returns that go hand n hand with mutual funds.
Even worse is the fact that the past performance touted by the advertisements and financial salespeople isn’t even real. Mutual funds regularly kill or absorb non performers, which conveniently keeps them “appearing” as if they are doing remarkably well, when in fact, their stellar averages and performance ratings are self created.
How to Retrain Your Brain
Of course, as with anything else, the first step involved in changing the way you think is to recognize that you’ve been duped in the first place. Don’t feel bad, we’re all wired to rely on past performance. Just know that in the world of investing, past performance is not an indicator of future results. Markets are random and no one can predict the future. One catastrophic event can wipe out a company or cause huge financial setbacks to an entire industry. That’s why a broadly diversified portfolio with investments that don’t track together, costs that are cut to the bone, and regular rebalancing are the keys that we continue to advise.
You can’t listen to advertisements. You’re going to have to turn yourself off from all of it. Investment advertisements, regardless of how genuine they sound, are nothing more than cleverly crafted sales pitches. David Swensen’s advice to individual investors is simple, “Take control of their financial destinies, educate themselves, avoid sales pitches, invest in a well-diversified portfolio of low-cost index funds.”
Let’s recap: Past performance does not predict future results. 100% true in investing. Not true in many other areas of life. Learn to separate the two in your mind.
Bryan Binkholder, The Financial Coach, is a catalyst for change in the financial industry. With a true passion to make a difference, Bryan offers practical insights on financial topics, investment strategies, and business success. As a business advisor, motivational speaker and author, Bryan is best known for exposing the inner workings of Wall Street and bringing clarity to common investment misconceptions. Be sure to take advantage of his two most popular resources: 7 Deadly Traps of Investing and The Six Pitfalls of Retirement Planning and look for his latest book, 401(k) Conspiracy, authored with Jim Winkelmann of Blue Ocean Portfolios. If you are a business owner, plan sponsor, or 401(k) plan participant, you’ll want this information.