I've often said that choosing funds based on past performance is much like driving a car looking through the rearview mirror. It may work for a while but eventually it will lead to problems.
Chasing performance is very dangerous, yet it happens over and over again. Performance sells and that is the unfortunate reality. Last year's top performers always attract the most new money and investors follow like sheep. My advice is simple: don't chase last year's winners! Why? Because performance can be very misleading. Here's some advice on how to use performance to make better decisions.
- Use Objective Benchmarks. Some investors would be happy with a 7% compound return over the last five years, while others would be unhappy with that kind of return. Performance is subjective, and as a result, we must use realistic, objective performance benchmarks.
- Think Portfolio Instead of Individual. Investors often look at their portfolio of mutual funds and zone in on the weaknesses. For example, you may have a portfolio of five funds with returns of 31%, 15%, 10%, 6% and -8% and immediately you second-guess the fifth fund. Remember, a properly diversified portfolio will often have components that under perform from time to time.
- Compare Apples to Apples. Comparing global equity funds to Canadian money market funds is like comparing apples to oranges. It is very misleading and inappropriate.
- Remember Time and Patience. Despite any random short-term ups and downs, over time, mutual funds will appreciate given time. It's difficult because we live in a society where the path of least resistance is best and there is little time for patience. Just remember the cardinal rule to investment success is to be patient, patient, patient!
- Risk Determines Performance. If investors take the time to understand what risk really means and how much they are really willing to take, they can manage their expectations of return more effectively.