Past is Not Prologue

Many investing advertisements tout past results to earn your confidence in future performance. This is only natural; in most endeavors we look to the past to predict the future (does anyone shop for an inexperienced plumber, or a doctor with a host of malpractice lawsuits?).

As with most things in the world of finance, though, our gut instincts lead us astray. Past mutual fund results have almost no predictive value for future returns.  Take, for example, technology funds in the 1990s that were crushing the market year after year.  Then, one day, they imploded and lost well over half their value.  If a fund manager is beating the market when s/he is out ahead of a trend, it is generally only a matter of time before that trend starts to work against the fund and the market tops over it.

Even though the government requires mutual funds to specifically disclaim such a connection (“past performance does not guarantee future results”), most potential investors will assume that past results are predictive of future success. This assumption is wrong, as several academic studies have demonstrated that past performance has almost no predictive value for future returns. In fact, one recent study recommended that the government replace its current disclaimer with a new one: “Do not expect the fund’s quoted past performance to continue in the future. Studies show that mutual funds that have outperformed their peers in the past generally do not outperform them in the future. Strong past performance is often a matter of chance.”

Reference:  New York Times’ “Bucks Blog“