Past performance doesn't always mean future success. In fact, according to Vanguard, the king of low-cost and self-directed investing, making investment decisions based on past performance alone can actually cost investors.
But there's good news: there are ways to break the cycle, and in large part, all it requires is self-reflection and self-control. "We're creatures of habit. It's human nature to rely on what we've learned in the past – we won't (knowingly) touch a hot stove twice, in other words," wrote Shyam Yekanath, project manager at Vanguard Investment Strategy Group, in a research report. "Old habits die hard though. While you might not be able to eliminate the influence of past performance when selecting your investments, you can take measured steps to achieve a more balanced approach."
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According to Yekanath, in order to fight the urge to make investment decisions based on how funds or stocks have done in the past, investors have to be aware of their current situation and the predictability of the past repeating in the future. That may be easy when choosing to eat at a particular restaurant again, but stock market performance tends to be unpredictable, making it unproductive to rely on past performance. After all, one day the stock market is declining over fears of a trade war breaking out, and the next day it is up again because those concerns have been tempered. According to the Vanguard executive, research has shown that investment performance is more random than predictive.
In addition to being aware of the current market conditions, investors should focus time and energy on asset allocation instead of pouring over the performance of a particular mutual fund or exchange-traded fund. "There are predictable benefits to choosing low-cost investments and maintaining an appropriate asset allocation," wrote the Vanguard strategist. "Low-cost investments can help you keep more of your returns, and a suitable asset allocation can help you manage risk. On the flip side, there are no predictable benefits to making investment decisions based on past performance." In fact, Yekanath said that asset allocation affects investors' returns more than any other choice they make, including past performance.
Because of a lot of what happens with stocks is out of the control of investors, Yekanath advocates a disciplined approach to investing. That means creating a financial plan with clear goals and an asset allocation that takes into account risk tolerance. Once it's created, stick to that plan, even if the markets are declining over a presidential tweet or the latest data scandal. That is a better way to ensure good returns than looking at the one-, three- and five-year performance of a fund.