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Does Past Performance Equal Future Performance?

Every day you can look in the newspapers and find a sea of mutual funds. No matter where you look, you will always find the 1, 3, 5, and 10-year numbers up to a certain date. These are industry standards. Any time performance numbers are published, you will find this data.

So we've established that this information is everywhere: the internet, the newspapers, advertising, newsletters, and yes your mutual fund sales person. Then you take the fact that people are selecting mutual funds based on this very common information. Investors and advisors are using this information every day to form the foundation of which funds they will invest in. Take a look at this example:

Which Canadian Equity Fund would you buy?

1 year 2 year 3 year 4 year 5 year
Fund A 5.7 11.5 15.9 15.9 13.6
Fund B 11.4 9.9 12.6 12.5 8.7

Most people given this information would choose fund A over fund B. Why? Something I call investor psychology. If it has done better over the last 5 years, it is more likely to do better in the next 5 years. This is not right or wrong but simply a reality. If you take a look at fund flows, which simply means which funds are being bought and sold, there is a very strong correlation between last year's best performing funds and this years best selling funds.

So what's the problem with this thinking? Simple! It does not work! If it were that easy, we would not need thousands of mutual fund choices and we would not need investment brokers. We would simply buy last year's winners knowing that they will be this year's winners.

Results don't lie!

You probably figured out that fund A and fund B are real funds. I simply masked their identity because I do not want anyone to think that either fund is necessarily better or worse based on such limited information. The point of this exercise is these were real numbers to the end of December 31, 1998. I would guess that if we were playing a game and we each invested $100 in one of those two funds back in 1998, 90% of you would have chosen fund A. So who would have done better?

1 year 2 year 3 year 4 year 5 year
Fund A 20.4 15.2 10.3 14.1 14.3
Fund B 81.4 57.7 31.9 28.2 25.5

The 10% of you (be honest) that chose fund B would have been about 3 times ahead of all of those who choose fund A – the opposite of what our psychology told us.

Yet, we do it over and over again! Fund B, has grown by 550% in new money and fund A is in net redemptions. It's funny how investor psychology works.

Moral of the story

Fund A is neither better nor worse than Fund B. Which one will fare better one year from now? Only time will tell because no one can accurately predict the future. In this example we have a 50/50 chance of picking the winner!

If we keep the odds at a 50/50 chance, what are the chances of picking this year's top half of mutual fund performers and having them remain in the top half the following year? According to the research in my book, the answer is 38.3%. What are the chances that these same funds in the top half will be in the bottom half next year? 41.9%. Chasing performance still leaves us poor odds no matter how many choices we have.

In the end, good research leads to good decisions. To properly pick mutual funds, you cannot look at performance and performance alone. You must look at a myriad of aspects like risk, fees, mandates, managers, disciplines, etc. I guess that's the reason why ‘past performance is no indication of future performance'.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

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