Understanding how performance fits in with your overall investing strategy can keep you from developing tunnel vision
Past performance is no guarantee of future results. That’s an often repeated phrase in investing. Investors, however, seem to be of a different mind. In a TIAA-CREF survey, 36 percent of respondents pegged one-year performance as the most important indicator of an investment’s return.
Forty-seven percent of investors said they’d chosen mutual funds based on the preceding year’s performance, without looking at historical returns.
Basing your investment strategy on past performance (especially recent performance) can easily backfire.
Annualised rates of return mask a lot of the variability that investments experience assets that have performed well may not continue to do so.
In fact, assets that have performed the best in recent years may be the ones poised for a downturn, they may be so overvalued that they’ve become riskier choices.
Relying on The Party Effect or Recency Bias is where stock market participants evaluate their portfolio performance based on recent results or on their perspective of recent results and make incorrect conclusions that ultimately lead to incorrect decisions about how the stock market behaves.
Using past to guide investment decisions can be particularly dangerous when the market is on an upswing. Investors move into the market hoping to capitalise on rising prices, even when signs may be pointing to an impending correction.
It’s future performance that counts. If you’re investing long term, your perspective should reflect that.
Look ahead, rather than backward, most financial reports represent the past, but almost all of the value of a business is in the future.”
The difficult part of investing, he says, is trying to bridge the gap between what’s happened and what lies ahead.
That entails asking the right questions. Investors often aim for the same rate of return that an investment has delivered in the past. Instead they should consider why the company earned such high returns in the past, and how likely it is that those same factors will continue enabling the business to outperform.
Looking at Standard & Poor’s 500 index as an example of how investor expectations don’t always match reality.
The statistical expected return of the S&P 500 is about 11 percent, but annual returns since 1928 have ranged between -44 percent and 53 percent. That wide gap illustrates the inconsistency in stocks and their variability over shorter periods.
To ride out periods of volatility, you’ll need to manage your expectations. Otherwise, basing decisions on recent performance could prompt you to buy and sell at inopportune times.
You’re better off tempering your expectations of past results with a rules-based approach that includes your risk tolerance.
That’s particularly true for investors who are living off their portfolios and trying to maintain their investments while still pursuing growth.
Taking on too much risk to chase a benchmark can expose your portfolio to larger losses, which are then compounded when monthly income is drawn off your nest egg.
Diversification is your strongest line of defense against market volatility. As you mold your portfolio, it helps to think of it as a group effort.
Just like a football team, which assigns faster players to do the running and stronger players for blocking and catching, your portfolio needs to have different asset classes and securities that play different roles.
You don’t want everything producing the same level of returns. Different investments in a portfolio should be working in concert with one another, not marching in lockstep.
Diversification can help minimize any negative consequences of chasing past performance with a specific investment.
One of the biggest risks many investors face is not a total loss of their portfolio’s value, but failing to meet their financial goals because they take an inappropriate level of risk.
For some investors, it’s too much risk; for others, too little. Creating a comprehensive picture that includes the risks for volatility, liquidity, leverage and market-affecting events can help you determine your asset allocation without being unduly swayed by performance.
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