Introduction
Whenever you read a mutual fund prospectus or any investment material, you will almost always come across a phrase that says, “Past performance does not guarantee future results.” You will find this warning attached to everything from insurance products to cryptocurrency funds.
Not Just Good Advice, It’s the Law
Asset management companies are required by the regulations of the Securities and Exchange Commission (SEC) to remind you that past returns of assets do not mean that future returns will be similar. This is partly because many of them use past performance as part of their advertising campaigns.
Performance is Open to Interpretation
The way a company calculates past performance can be misleading. You might think it is growing, that profits are high, and that there is cash flow throughout the company based on its reports. In reality, the company may be barely making a profit.
Often, it is the investors themselves who cause prices to rise and fall. Most of the time, they trade at the wrong times, allowing their emotions to control their decisions. They buy more during rallies and sell more during declines. If it seems there is a downward trend in the future, many begin to panic.
If you are trying to build wealth, this is a losing strategy. Once you take inflation into account, you are likely seeing a loss even if you have some growth in percentage terms. If you do not see returns that exceed the inflation rate, you are losing money.
Hockey star Wayne Gretzky sealed the secret to his success. He said a good player should skate “to where the puck will be, not to where it is.” When analyzing a company or mutual fund, many should adhere to the same advice.
Performance Often Changes
Past returns can be useful when analyzing a stock or investment fund. The most important action you take is to consider it over a long time period. If a stock has risen 15% in a year, you will not know if it is a good investment now. That does not tell you whether it will be good in the future. It simply tells you what it did over that annual period.
However, if a stock has shown an average annual return of 9% over more than 40 years, that is good. No one can promise you anything about this stock. But a stock that has managed to withstand 40 years of market ups and downs certainly can provide insight into future growth potential.
When analyzing past returns, it is best to ignore returns from just the last few years. Try to focus on returns over 10 years or more.
Questions to Ask About Past Performance
How can you protect yourself from getting involved in a hot sector, fund, stock, or asset class? If you are considering an investment, pause and ask yourself some questions. Taking the time to answer these questions may help protect you from making an emotionally driven investment decision:
What makes me think this company’s earnings will be higher in the future than they are now? If there is little or no chance for growth, why should I invest now? If I believe the company will grow, what are the risks to that earnings hypothesis? How likely are these perceived risks to turn into actual realities? What are the worst things that could happen to this asset or fund? Why has the company not been successful in recent years? Has this sector, industry, or stock seen a rapid price increase in the last few months? If so, why do I think it will continue to grow at this speed? Am I buying or selling based on the asset’s value, or am I doing regular purchases, or trying to time the market? If there is a significant deviation from the mean, what makes me think it won’t revert back? How do I know this is the new normal?
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Source: https://www.thebalancemoney.com/past-performance-is-no-guarantee-of-future-results-357862
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