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Why Past Performance Does Not Guarantee Future Results: A Guide for Savvy Investors



Past Performance Does Not Guarantee Future Results: Popular Quote/Disclaimer

If you have ever read a mutual fund prospectus, an investment newsletter, or any other financial material, you have probably seen this phrase: Past performance does not guarantee future results. But what does it mean, and why is it important for investors to understand?

What Does It Mean?

The phrase past performance does not guarantee future results is a standard disclaimer that is required by the Securities and Exchange Commission (SEC) for any investment product or service that uses past performance as part of its advertising or marketing1. The SEC wants to remind investors that investing involves risk, and that the returns or performance of an asset in the past may not be repeated or sustained in the future.

The phrase also implies that past performance is not a reliable indicator of future performance, because there are many factors that can affect the performance of an asset, such as market conditions, economic cycles, investor sentiment, competition, innovation, regulation, and random events. Therefore, investors should not base their investment decisions solely on past performance, but also consider other relevant information, such as the asset’s objectives, risks, fees, and performance over different time periods.

Why Is It Important?

The phrase past performance does not guarantee future results is important because it warns investors against a common behavioral bias called recency bias. Recency bias is the tendency to give more weight to recent events or information than to older or more distant ones. In investing, recency bias can lead to performance chasing, which is the practice of buying assets that have recently performed well and selling assets that have recently performed poorly, without regard to their long-term prospects or valuation.

Performance chasing can be detrimental to investors’ returns, because it often results in buying high and selling low, which is the opposite of what investors should do. Performance chasing can also increase the costs and taxes associated with investing, as well as expose investors to higher volatility and risk. Research has shown that performance chasing can reduce investors’ returns by as much as 1.5% per year2.

How to Avoid It?

The best way to avoid performance chasing and recency bias is to have a clear investment plan and stick to it. An investment plan should include the following elements:

  • An investment objective, which is the goal or purpose of investing, such as saving for retirement, buying a house, or funding education.
  • An investment horizon, which is the time period over which the investment objective is expected to be achieved, such as 10 years, 20 years, or 30 years.
  • An asset allocation, which is the mix of different types of assets, such as stocks, bonds, cash, and alternatives, that is appropriate for the investment objective and horizon, as well as the investor’s risk tolerance and preferences.
  • A rebalancing strategy, which is the process of periodically adjusting the asset allocation to maintain the desired level of risk and return, as well as to take advantage of market opportunities.

By following an investment plan, investors can avoid being influenced by short-term fluctuations in the market or the performance of individual assets, and focus on the long-term outcomes that matter. An investment plan can also help investors diversify their portfolio, which can reduce the impact of any single asset’s performance on the overall portfolio’s performance.

Conclusion

Past performance does not guarantee future results is a popular quote and disclaimer that investors should pay attention to. It reminds investors that investing involves risk, and that past performance is not a reliable predictor of future performance. Investors should not base their investment decisions solely on past performance, but also consider other relevant information, such as the asset’s objectives, risks, fees, and performance over different time periods. Investors should also have a clear investment plan and stick to it, to avoid performance chasing and recency bias, and to achieve their long-term investment goals.


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