Past Performance Does Not Predict Future Performance

If you've been investing for more than 15 minutes, you've probably heard the saying "past performance does not predict future performance" so something like it. It's set up as a disclaimer by brokers and mutual fund companies to let you know that whatever they're selling you does not have any guaranteed performance attached to it (all the while, they are implying that it does!) But it's really true -- past performance does not predict future performance. Here are some thoughts from the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on the subject:

According to an Investment Company Institute study, about 75 percent of all mutual fund investors mistakenly use short-term past performance as their primary reason for buying a specific fund.

Why is this? Because the fund companies and financial media constantly pump short-term performers.

The book goes on to list several studies on this issue. A few of the highlights:

• "The portfolios that finished the first five years [of a study] in the top quintile were the least likely to finish in the top half over the next five years."

• "Past performance cannot be used to predict future returns, or to infer the average skill of active managers."

• "Of the top-20 U.S. equity funds during the 10-year period, only one stayed in the top 100 in the subsequent 10-year period."

Yep. I learned this the hard way early on in my investing career.

What's their solution for this situation? Invest in index funds. That's what I do, too.

For more on investing, see Best of Free Money Finance: Investment Posts.

Comments

[Monty Loree]

Do you ever use trading softwares that help analyze stocks for you?

I've heard that software programs such as traderzone(dot)com, pre-analyze the stock market on a daily basis.

This gives you much better control, if you're a hands on stock trading person.

[FMF]

I would not classify myself as a hands-on stock investor, so I don't use anything like you're describing above. I buy few stocks relative to the rest of my portfolio (mostly index funds.)

[Duane Gran]

The phrase ""past performance does not predict future performance" is required boiler plate, per the Investment Company Act of 1940 whenever Broker/Dealer or Advisor/Representative publishes about the performance of a fund or issue. In spite of its self-evident truth most investors are chasing yesterday's winners.

Some of the blame goes to the people who sell securities, but the buyers are complicit. Many investors salivate for activity and become enchanted with past performance, both of which tend to erode returns.

[Jesse]

I pretty much just don't look anymore. I throw my money at index funds and go throw another burger on the grill.

[Miller]

FMF, I love your style! I can't agree more myself. I read the "Four Pillar of Investing" which gives the same type of numbers. The author is in the same camp as Bogle. In fact, I am currently reading "Bogle on Mutual Funds." Index funds all the way for me (where I can, at least).

Part of me is interested in hearing "the other side" though. We all know statistics never lie... but sometimes they can be made to say different things! I'm not suggesting Bogle does that (like I said, I'm 100% supportive), but I think it would very valuable to read a book by someone trying to refute the index fund approach! You?

[Greg R]

Random walk theory tells us "that stock prices have the same distribution and are independent of each other, so the movement or trend of a stock price or market cannot be used to predict its future movement."---Investopedia.
Instead of specific past performance numbers, use management skin in the game (want lots), management quality and consistency, fees and expenses (low), and risk (as measured by mean, standard deviation, the Sharpe ratio, beta, etc.) as you find in Morningstar. Also check out Bogle's Common Sense on Mutual Funds.
For the primer on random walk, check out Malkiel's A Random Walk Down Wall Street.

[Duane Gran]

Miller,

See the following for a brief but effective rebuttal of the index investing strategy:

http://www.searchlightcrusade.net/posts/1147577266.shtml

I still think index investing is a good strategy, but the author brings up a lot of very good points.

[FMF]

Miller --

There are a gazillion other theories on how to pick stocks. They all work extremely well (you make 20% per year or more) in theory. In practice, there are very few people who actually beat the market year after year.

I knew all this long ago, but picked my own stocks anyway. The school of hard knocks was my learning ground where I found out that indexing was a much better alternative for me.