Last Updated: December 7, 2021
The Securities and Exchange Commission (SEC) requires funds to inform investors that previous performance does not guarantee future outcomes.
Even though this warning is emblazoned in investment firm descriptions, echoed by the financial media, and repeated by professionals giving investment advice, most individuals ignore it.
The idea of using the rearview mirror as a crystal ball is a human trait. As human beings, our brains are wired to look out for patterns. To trace patterns in any endeavor, we rely on past performance.
As such, it is no surprise that most investors use previous performance to estimate a stock's or investment's future worth. It is expected that if a stock's price is declining, it will continue to decrease. On the other hand, if a stock's price is growing, it will continue to do so in the future.
According to research, attempting to persuade investors otherwise may backfire, resulting in the opposite of desired behavior. In a study published in the Journal of Experimental Psychology, behavioral scientists tested disclaimers about past investment performance on 1,600 people in the United States.
They found that, despite the disclaimer, people overwhelmingly disagreed with it, going on to vote in funds that had previously produced impressive financial returns.
There have been arguments put up to refute the concept that previous performance does not guarantee future results. The most popular version of this viewpoint was reported in a 1997 research by Mark M. Carhart.
The customary caution that previous performance is not predictive of future results was put into doubt by Carhart's famous analysis, titled "On Persistence in Mutual Fund Performance."
Carhart utilized data to demonstrate that a fund's success in the previous year can assist forecasting how it would perform in the coming year.
In their new analysis, James Choi and Kevin Zhao (both of Yale University) found that though Carhart's assertion was right at the time, such correlation does not exist in present times.
Choi and Zhao duplicated Carhart's mutual fund study from 1963 to 1993, then extended the analysis to the current day. They also discovered that a fund's performance from 1994 to 2018 is unpredictive of future returns.
Only the years before 1980 showed a statistically significant association within the period studied by Carhart. If you pursue prior fund results, you tend to do a little bit worse over the last two decades.
It is very possible that a company's approach to calculating historical performance could be misleading.
For example, Zillow had to shut down its home-buying unit due to mispricings and wrong forecasts caused by its algorithms. The company had used rising house prices to forecast future demands. However, the company got blindsided when housing prices began to fall earlier than expected.
This led to a pre-tax loss of $422 million in its house-flipping segment. As the Carhart example demonstrates, it is quite easy to misinterpret data if all context is not well stated.
When examining a stock or fund, previous returns might be useful.
The most important thing you can do is think about it over a lengthy period. You don't know whether a stock is a good investment now if it rises 15% in a year. It does not indicate whether or not it will be excellent in the future. It just informs you what it did in the previous year.
It's a positive indicator if a stock has averaged annual returns of 9% for more than 40 years. Though this does guarantee future performance, a stock that has survived 40 years of market ups and downs has a higher chance of performing well in the future.
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There are questions that investors can use as guidelines when evaluating an asset based on its past performance.
You have to take into account other factors such as business cycle, interest rates, management moves, etc. this would give you a clearer perspective of why the stock moved and if it has the capacity to build on that momentum.
Also, consider the future performance based on industry forecasts and how the company is adapting to changes in its sector. Pay close attention to the company's competitive advantage over its peers.
There are so many companies which performed well in the last decade but can't compete with newer rivals.
Keep an eye on the company's finances.
For assets such as commodities or bonds, look at the market sentiment of the asset. For example, the belief that gold is an inflation hedge is seriously being questioned, especially in the light of other alternative cryptocurrencies.
Also, look at government policies and consumer tastes which would affect the demand of assets. For example, due to the announcement towards cleaner energy, oil company stocks which have been long regarded as a good source of dividend are becoming less favored by investors.
Questions such as this give a balanced assessment of an asset's viability over time.