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The 5 Faults of Filtering by Historical Returns

When searching for an investment advisor, the first question is often, “What is your past performance?” This question is asked with the best intentions—you probably wouldn’t want to give your money to someone who consistently loses money—however, the question also makes five fatal assumptions. For these reasons, you should be careful using the question to filter out potential candidates.

1. Past Performance Is Not Indicative of Future Returns

This is the most common refrain in any investment disclaimer. Just because something happened previously does not mean it will happen again. However, this warning hasn’t stopped unregulated advertisers from trying to convince you otherwise. For example, I recently saw an ad on television encouraging people to buy gold. The spokesperson said something like, “From 2010 to 2012, gold was up a staggering 92%.” 

I don’t know if those were the exact numbers in the ad but the exact numbers are beside the point. The only relevant fact is that the return of gold in 2010–2012 has no relevance to the likely return on gold in 2017. It is simply a way to help the buyer dream big, focus on the best case and discount the fact that gold has lost approximately 22% of its value over the previous five years. (For related reading, see: Is Gold Regaining Its Shine?)

2. Past Performance Is Not Equivalent to Risk Adjusted Returns

Investors will often put two portfolios side by side and choose the one that has a better result. However, this strategy ignores the risk the investor took to achieve the outcome. For example, a portfolio with two small cap stock positions is going to be much riskier than a portfolio that holds 500 large cap stock positions, which is going to be riskier than a portfolio that owns a handful of short duration government bonds.

To help compare apples to apples, investors should use metrics like the Sharpe ratio to adjust for risk. According to Investopedia:

“The Sharpe ratio is a measure of an investment's excess return, above the risk-free rate, per unit of standard deviation. It is calculated by taking the return of the investment, subtracting the risk-free rate, and dividing this result by the investment's standard deviation. All else equal, a higher Sharpe ratio is better.”

In addition to seeking the highest risk adjusted returns, investors should seek out portfolios matched to their specific goals and risk tolerance. A volatile portfolio may have terrific point-to-point returns over the long-term, however, that doesn’t do an investor much good if she sells out of fear when the price goes down in the short-term.

3. Strategies Can Change Over Time

When an active portfolio manager talks about her historical performance, it is important to remember that her strategy may have changed from one year to the next. For example, a portfolio that was heavily invested in bonds in a declining interest rate environment but shifted towards stocks in 2009 may show great returns and very low historical levels of drawdown. However, the allocation going forward may have a completely different risk profile today than it did 10 years prior. (For related reading, see: Active vs. Passive Investing.)

4. Cherry Picking Proposed Allocations

When a potential client gets a proposal from an investment advisor, it usually includes an illustration reflecting how the proposed portfolio would have grown historically relative to a benchmark. However, it is important to remember that this proposal is easy to manipulate. Since it is backwards looking, an advisor can simply pick the funds that performed the best and infer that had you been his client, you would have owned these funds for the length of the illustration.

The reality may be much different. Past performance is not an indicator of future returns and the funds that did well over the previous five years may not be the best over the next five years. Accordingly, if an advisor shows you an allocation and promotes the five-year performance, be sure to ask if she actually owned that same allocation five years ago.

5. Short-Term Returns Are Not Necessarily Indicative of Long Term Returns

When a potential client comes into my office, it isn’t uncommon for her to propose splitting assets between myself and another financial advisor saying something like, “I’ll try you both out for a few months and see who has the better returns.”

“I have no problem with you splitting the assets” I might say, “but please don’t believe that my returns or the other guy’s returns over a six-month period have any bearing on your long-term financial plan or our value-add as advisors.”

In the end, markets fluctuate and there will be years when any given allocation underperforms or overperforms expectations. Rather than selecting an advisor based on short-term investment results, the wiser approach is finding the advisor most capable of providing the guidance you need to accomplish your goals regardless of market conditions.

(For more from this author, see: The Hidden Cost of Hedge Funds.)