The Dangers of Investing Based on Past Performance

Past performance does not necessarily predict future results.

Every investor has seen these words before. But not enough of us take them to heart.

Morningstar, perhaps the world’s best-known fund research firm, gives mutual funds a rating out of five stars based on past performance.

There’s nothing wrong with the rating system itself – trailing indicators like past performance can be useful when supplemented with other research.

The problem is that many investors take Morningstar’s ratings as gospel – paying more attention to this trailing indicator than anything else.

As The Wall Street Journal recently reported, five-star funds get net inflows in 69% of the months they hold that rating. One-star funds get net inflows in just 29% of the months they hold that rating.

And as you can see from this week’s chart, the ratings tend to converge after a few years.

So why do so many investors continue to put so much stock into this rating system?

Recency Bias

As Chief Investment Strategist Alexander Green has written before, investors are vulnerable to something called the “recency bias.” That’s the human tendency to assume that the far future will reflect the recent past. It’s a fallacious assumption. And it’s the key psychological ingredient in stock market bubbles like the ’90s dot-com boom.

As Alex wrote back in August…

When technology and internet stocks were hot in the late ’90s, for example, investors began talking of a “New Era” of limitless technological growth.

Technological innovation does tend to increase steadily. Alas, the same cannot be said of technology stocks.

Years of rising prices lulled investors into a false sense of complacency. And when the dot-com bust came, the technology-laden Nasdaq index lost over three-quarters of its value – and took a full decade and a half to recover.

The dot-com bubble might be the most egregious example of investors projecting the short-term past into the long-term future. But investing based on Morningstar ratings is based on the same flawed logic.

So how do you protect your portfolio from recency bias?

Rebalancing for Past Performance

In essence, you do the opposite of what the Morningstar rating system suggests you should do.

A properly asset-allocated portfolio should be rebalanced at least once a year. Rebalancing, as you probably know, is the process of selling off some of your highest-gaining investments and reinvesting the money into your lowest-gaining assets.

Alex’s Gone Fishin’ Portfolio in The Oxford Communiqué operates on exactly this principle. He recommends rebalancing your portfolio on the last day of each year.

Selling off your biggest winners and buying up your biggest losers might feel counterintuitive… but it minimizes your cost basis and reduces your portfolio volatility.

Plus, it keeps you from settling for the mediocre returns that come from following Morningstar ratings and other trailing indicators.

— Samuel Taube


Source: Investment U