Picking investments based on past performance

Invariably people will see a ranking of highest performance funds for the last year or so and ask “Are these good funds?” Others will just go and blindly buy them. In fact, there is a huge proportion of investors out there who base most of their decision on the past performance of an investment alone.  They do not research any further than the performance report for the last year.  This is no different than gambling in my eyes!

To paraphrase a quote I once heard, if all that was involved in achieving the highest rate of return was looking at past performance – librarians would be the richest people on earth! Last time I checked, they were not (at least on average).

In fact there have been numerous studies that have looked at mutual fund rankings year over year.  What they all find is that the #1 performing mutual fund over the last year will be very close to the worst performing fund the next year. These studies are numerous and they all have the same results.  In fact, the worst performing funds also have a tendency to shoot up the rankings the following year.

So what does this tell us?: That you cannot blindly look in the newspaper and look for last year’s best performing fund and expect it to give you the same performance every year.  In fact, if you take nothing else away from this post take this: Next time you see a mutual fund returning over 50% in the last year, take a look at it’s 5 and 10 year averages.  If the longer term averages are, say closer to 10%, then doesn’t it stand to reason that to revert to the mean will require some dismal performance in the future?

What I’m really trying to advocate is that you should take some time to get advice and do some research on what you are buying.  I’m convinced that people take more time choosing between fridges for their house than they do their long term investment selections! I realize that a lot of people are quite intimidated by the task, but do your due diligence! Again at the very least, if you are still going to go out and buy yester year’s hot performer – ask for a professional’s two cents on the fund first! Even the fund company who sells the fund will tell you not to expect the performance to continue forever!

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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