You hear advisors on TV talking about how they research and pick the securities with the highest returns. That sounds good since who doesn’t want the best? Why not jump in and catch the wave? Here are three reasons why not.
1. The past is too late. Those returns did happen, but the investment isn’t already in your portfolio. Regardless of how good they were, you don’t get the past returns of the investments you weren’t in.
If you take an old investment out and put a new investment into the portfolio after you notice it had better return, you get the returns of the lower performing investment. So you see the shell game? Switching out a lower performing investment gives you an illusion that your returns improve.
2. The future is unpredictable. Past performance does not guarantee future returns. You see this in every disclosure. Yet many still have the misperception that they can look at past returns to determine the future return of that investment.
Numerous studies have found that funds that did well in the past do not consistently go on to do so. The Standard & Poor’s ongoing reports on funds performance show that managers don’t year after year outperform the indexes.
I agree with advisor Daniel Solin’s article that we need a stronger disclaimer to better remind investors of this fact. A study he cites found that a more effective disclaimer would be: “Do not expect the fund’s quoted past performance to continue in the future. Studies show that mutual funds that have outperformed their peers in the past generally do not outperform them in the future. Strong past performance is often a matter of chance.”
3. Outperforming is not your goal. The real objective of investing is achieving your life goals, such as a sustainable retirement. That has more to do with your savings and spending rates that it does with returns. And unlike the returns the markets deliver, you can control how much you save or spend.
So how should you invest? Rather than chasing returns, simply invest in broad indexes and get what the markets give you – good and bad. This approach allows you to dial in the level of risk. You don’t get the occasional outperformance, but you also don’t underperform, either. Unless there are systematic risks – when the economy tanks, like it did in 2008 – you get consistent returns that match the markets.
One can wish for good returns all the time. But that is not how the markets work. Unexpected news and all participants’ expectations and reactions to it move prices. Your part is to let the markets work over time.
Larry R. Frank Sr., CFP, is a Registered Investment Advisor (California) in Roseville, Calif. He is the author of the book, Wealth Odyssey. He has an MBA with a finance concentration and B.S. cum laude in physics with which he views the world of money dynamically. He has peer-reviewed research published in the Journal of Financial Planning.
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