Misconceptions About Past Performance And Future Returns

By Amy Fontinelle | March 12, 2012 AAA
Misconceptions About Past Performance And Future Returns

Beginner investors, along with many experienced investors who should know better, have a tendency to look at an investment's historical returns when deciding whether to buy. After all, we look at the past performance of many things in our lives to gauge how they might perform in the future. We buy Hondas and Toyotas because of their reliable histories; we admit students to college based on their high school transcripts; we reject a would-be suitor who cheated on his or her ex. However, when choosing an investment, past performance should be only a minor consideration. Here's why.

SEE: Using Historical Volatility To Gauge Future Risk.

Why You Can't Rely on Past Performance
No one wants to buy a losing investment. It would be psychologically difficult for anyone to purchase a stock, mutual fund or ETF with a history of poor performance. While poor-performing investments can represent a profit opportunity for investors who know how to analyze fundamentals, most people don't want to take that kind of risk. Instead, they seek out investments that have had spectacular results in recent months or years.

However, if you buy an investment simply because it's performing well, without knowing why it's performing well, you're bound to get burned when market conditions change. Instead of looking at an investment's past performance to decide what to buy, here's what you should look at instead.

Fees
No matter how an investment performs, the fees you pay to buy, sell and hold it will diminish your returns. You might think that higher fees equate to a higher-performing investment, but the reverse tends to be true. For these two reasons, investment advisors recommend seeking out investments with the lowest possible fees.

Here are the types of fees you're most likely to encounter, how much they'll typically cost you and how you can minimize them:

Trading Commissions
When you buy or sell a stock, you'll have to pay a fee to do it. The fee will usually be the same whether you buy one share or 100 shares. The more often you buy and sell and the fewer shares you transact in, the greater the percentage of your potential returns will get eaten up by trading commissions.

When choosing a brokerage, look for one with low trading commissions (preferably below $10 per trade) if you plan to invest in individual stocks. Make infrequent, carefully planned trades to minimize your commissions. Not only will infrequent trading save you commissions, it will probably improve your returns. Frequent trading hurts most people's investment performance, because they tend to make emotional decisions that lead to buying high and selling low.

When buying and selling mutual funds and ETFs, it's often possible to avoid trading commissions. If you want to invest in Fidelity funds, for example, open an account with Fidelity and you'll have numerous commission-free options. On the other hand, if you wanted to buy another company's fund through your Fidelity account, you'd probably pay a commission.

Loads
A load, also called a sales charge, is a fee based on a percentage of your investment that some mutual funds charge when you buy and/or sell that fund. The sales charge gets subtracted from the amount of money you've invested. It's not uncommon to see a fund with a 5% load, but loads are not associated with improved investment performance and plenty of funds don't charge loads. Most investors should try and avoid funds that charge this fee.

Expense Ratio
All mutual funds and ETFs have an expense ratio, which tells investors how much they will pay per year for the fund's administrative and operating costs as a percentage of their investment. This fee helps cover the costs of the fund's managers, record keeping, client communications and other expenses.

You can't avoid this fee, but you should look for funds with low expenses for their investment type. Relatively speaking, international stock funds and small-cap funds will have some of the highest expense ratios, while index funds and domestic bond funds will have some of the lowest expense ratios.

Also, passively managed funds have lower expense ratios (and generally better performance) than actively managed ones. A passively managed fund should have a fee below 1%; sometimes this fee will be as low as 0.1%.

SEE: Passive Vs. Active Management.

Risk
How much risk do you need to take to achieve your investment goals, and how much risk can you tolerate? That fund with the spectacular returns might have earned 30% this year, but in a bad year it might lose 40%. Could you stomach a drop like that? If one of your investments lost that much value, would you have other investments to turn to if you needed to sell?

In general, investors can afford to take greater risks the further they are from retirement and the wealthier they are. Investing in small companies and international stocks tends to entail high risk, U.S. government bonds are considered very low risk, and investing in the S&P 500 falls somewhere in between.

Investors should consider both the risk of each specific investment they choose, as well as the total risk of their portfolios as a whole, when evaluating whether they're taking on the right amount of risk to meet their investment goals.

Performance Relative to a Benchmark
It's hard to know what to make of an investment's winning or losing performance without comparing it to similar investments. If you're considering a high-risk ETF but its performance is on par with lower-risk investments, it doesn't make sense to choose that ETF. You want to take as little risk as possible to achieve the highest returns possible. Similarly, if you're investing in a fund that has the goal of matching the performance of the overall U.S. bond market, make sure the fund is actually achieving that goal. If you're looking at buying an individual stock, look at how the stocks of similar companies have been performing.

Looking at benchmarks can also help explain an investment's performance. For example, if the S&P 500 has been tanking, a fund that has had similarly poor performance is not necessarily a bad fund; rather, its performance is a reflection of current market conditions. If a particular investment is doing exceptionally well in a bear market or exceptionally poorly in a bull market, you'll want to do further research to find out why.

The Bottom Line
Relying on an investment's past performance to guide your investment decisions is a losing strategy: today's top-performing investments often become tomorrow's losers and vice versa. Instead, look for investments with low commissions and fees, with levels of risk that are appropriate for your investment goals, and with performance that makes sense relative to an appropriate benchmark.

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