For a more in-depth read, check out The Intelligent Portfolio by Christopher L. Jones, Financial Engines’ Chief Investment Officer.
“History is more or less bunk.” — Henry Ford (1863-1947)
One of the most common mistakes investors make is basing investing decisions on history and past performance. It’s not entirely their fault. Human beings are wired to believe that the past will repeat itself. Some marketers of financial products know this and spend huge sums to reinforce our natural tendencies. They highlight stellar fund performance records to get us to invest in what appears to be a sure thing at first glance.
There’s only one catch: a strong historical investing track record doesn’t tell you much about future expected returns.
In general, future returns have very little to do with how well a fund did in the past. The past rarely repeats itself.
Historical data can be useful for understanding risks and how different assets move together, but it doesn’t provide much information about the level of returns we can expect in the future. Investment returns in one period are usually not correlated with returns in a subsequent period. Sometimes a fund that is doing well will continue to do well in the future, but just as often, it may not. You should never assume that past performance is indicative of how a fund may perform in the future.
Moreover, there are many future possibilities that have never happened before. Just because we haven’t experienced something yet, doesn’t mean it can’t happen. Your investment decisions should be based on what’s possible, not just on what’s happened in the past.
The future is uncertain.
The truth is that there’s a great deal of uncertainty about the investment returns we can expect to see in the future. How the stock market behaved in the past could look nothing like what we might experience in the future.
Once again, it pays to be a skeptical investor. You know that tiny legal copy at the bottom of every investment product (“past performance is no guarantee of future returns”)? It’s easy to skip over it because we see it so often, but it actually means something and it’s absolutely true. Be careful about extrapolating from the past to predict the future of your investments.
However, there are things that are very predictable. For instance, investment fees. You might not see the same fund performance in the future that you saw previously, but you can bet that you will be paying similar fund expenses as last year. Investment performance will vary from time period to time period, but the impact of fees is very predictable. That’s why paying attention to expenses is so important.
To get a better sense of what your portfolio could do, you need sophisticated analytics. They can help you determine the investment exposures of a fund, how well it did relative to an appropriate benchmark and the range of possible outcomes it might deliver in the future. Luckily, you don’t have to do all of that work yourself. Financial Engines has built its business around helping investors like you plan for their future retirement.