Investing: Does Past Performance Matter?

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Somewhere in every mutual fund offering is the cautionary language noting that “past performance is not an indicator of future outcomes.”  It’s a simple truth and one that many investors have learned the hard way,  by buying yesterday’s star performers only to learn that they they were betting on shooting stars, not great investors.

Now, a new study from Standard & Poor’s says that the evidence against performance chasers is stronger than ever. S&P analyst Srikant Dash  reached that conclusion after studying mutual fund performance across different time periods up until March 2010. Importantly, he took care to use fund data that was cleaned of something called the survivorship bias.  That phrase simply means that many fund companies quietly euthenize their poorly performing mutual funds by merging them into a larger, more successful funds. This erases the poor performance record from some data bases and makes fund managers, on average, look like better stock pickers than they really are.

The analyst looked at top mutual fund performers over three-and five-year periods, looking to see how a fund performed each and every year in those periods, and also whether funds that  performed in a top quartile over, say,  one five-year period were able to repeat the performance in the next five years.  What he found is that very few funds manage to consistenty repeat top-half or top-quartile performance. In the interests of full disclosure, S&P makes good money from index funds, and this study’s results certainly favor passive investing (index funds or ETFs) over active (mutual funds.) That said, it’s hard to argue with the statistics. Here are the major findings:

• Very few funds manage to consistently repeat top half or top quartile performance. Over the five years ending March 2010, only 1.7% of large-cap funds, 2.2% of mid-cap funds, and 4.6% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.

• Looking at longer term performance, 18.5% of large-cap funds with a top quartile ranking over the five years ending March 2005 maintained a top quartile ranking over the next five years. Only 12.7% of mid-cap funds and 25.0% of small-cap funds maintained a top quartile performance over the same period. Random expectations would suggest a repeat rate of 25%.

In the 1970s, two psychologists studied how people make decisions when facing uncertainty. The two psychologists, Amos Tversky and Daniel Kahneman, provided much of the research that has led to deeper insights into the behavior of investors, who face uncertainly at every turn. Unfortunately these insights have done little to curb our human frailties, as people (and that includes financial advisers) often pick investments for the wrong reason.