Past Performance, Future Results, and Faulty Thinking
Cluttered in the footnotes and disclosures of most any investment prospectus, fact sheet, commercial, presentation, or offering document lies these common words: past performance is no guarantee of future results.
Its meaning reveals itself overtly. Grasping the concept and its truths, however, is a different matter. Knowing its meaning and trusting its warning are two different levels of investment humility. On its face we understand an investment’s recent results don’t indicate its trajectory moving forward. Yet often, if left to our own devices, the first place we look for viable investment options is finding what’s been doing well. Similarly, if you’re the nerves-of-steel-value-finding person that hopes to unearth bargains rifling through the beaten down losers of the past, there’s no rule that says what went down must come back up.
S&P Dow Jones, a firm most are familiar with thanks to stock market indexes bearing their namesake, conducted a study under their SPIVA group to put the “past performance” disclosure to the test. In 2019 they found just 29% of US equity funds beat the S&P 1500 index. They then looked at that 29% of funds that “won” for a year. The study found that, after the first year of beating the index, only 47% of that group had maintained their top-quartile performance, and three years later, only 8% remained in the top quartile of performers. In other words, if you were lucky (or skilled) enough to identify the top performing funds for a year, chances are that same investment underperformed after. Similar studies exist that echo the same results. This seems to lend credence to the “past performance” disclosure’s accuracy.
Why then, do many investors, professional and retail alike, expect things to be different for investments they select? Data would seem to suggest you’re better off avoiding the top performing funds of the past, not putting them at the top of the list. It is counterintuitive and that may explain most the rationale, but we believe it’s more psychological than that. Because of this, the behavior can be corrected, or at minimum, accounted for when we make investment decisions. This can, in turn, lead to better wealth building habits.
In a piece earlier this year we laid out a couple psychological biases present in nearly all of us that can hurt the effectiveness of our decision-making, not only regarding investments, but more generally as well.
Representativeness is the psychological bias or mental shortcut we think most applies to investors and traders that fail to heed the “past performance” warning. It refers to our tendency to classify any new information we receive based on our past experiences. Essentially, when we’re presented with something new, we try to relate it something we’ve seen or done before, and we label it as such, even if that label doesn’t apply. Our brains love patterns, and they try to fit things into patterns we’ve seen before, or stereotypes that fit the patterns in our mind.
You see a man walking down the street in a refractive green vest wearing a hard hat with steel-toed boots and assume he’s a construction worker, not an investment banker. Representativeness gets us to that assumption. Like this, most examples of representativeness are harmless and can be efficient short cuts in our brain. However, it’s the cases where our assumptions or subconscious classifications lead us astray that the impacts can be more detrimental. You’ve been a dog person all your life. You see a seemingly friendly dog approach. Nothing in your experience tells you to be afraid of this dog so you go in to pet it, and it nips your hand. Your prior good experiences caused you to overweight the probability that this dog was nice and underestimate the chance it wasn’t. Or your toddler that’s been in a mood all night has once again barged into your room just as you’re about to fall asleep. Another nonsense game they’re playing to get out of going to bed, you think, and you snap at them to go back to their room. Your toddler approaches, gives you a big hug, and heads back to bed. That guilt you feel is representativeness backfiring on you. Your brain told you “oh, this again – I’ve seen this before” and gave little weight to the chance that this time they just wanted a hug; they weren’t there to pester you further. In investing, you might find a fund or stock that has been doing really well recently and think that performance is set to continue, not knowing the higher probability outcome is the opposite: the fund/stock is actually more likely to underperform moving forward. The strong past performance that attracts investors is hard to maintain, especially now that expectations are much higher. Then when you see it underperform, you’re more likely to give up on it and keep switching between investments, another move that usually hurts your long term returns.
Representativeness is a cognitive bias which means it’s caused more by faulty reasoning or imperfect short cuts in our own brains than it is our emotions leading us astray. This is good news because cognitive biases are easier to correct and correcting them can lead to making better decisions.
From the investing lens, correcting this bias may simply mean taking that “past performance” disclosure to heart and understanding it’s impossible to predict with any certainty which investments will be the best moving forward, and trying to predict that by looking backwards can be even more detrimental. Proper diversification, educating yourself on basic investing principles, and looking beyond short time windows help correct this. Experience does this as well. In our more obvious examples, consciously considering that not all dogs are friendly and not all toddler interactions are ill-intentioned can help keep our minds from jumping to pre-disposed conclusions, leading us to make more rational decisions. Rational decisions lead us to better outcomes.
We’d be more than happy to discuss this topic and others like it, in addition to any other investment or planning topics that are top of mind to you. Don’t hesitate to reach out to our team if you have any questions. Our hope with these pieces is at least one thing sticks with you and helps you in some way. We thank you all for your partnership and trust. We’re here should you need anything.
Disclosures
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
