Why Past Performance Is No Guarantee of Future Results

Any time you read a mutual fund prospectus or any investing material, you're going to come across a phrase that is close to this: Past success does not guarantee future performance. You'll see this warning tacked onto everything from annuities to virtual currency funds.

So why is it there, and what exactly does it mean? It goes deep within the process of making good decisions and managing your risk: It is the methodology that counts, not the recent scorecard.

Not Just Good Advice, It's the Law

Asset management firms are required by the Securities and Exchange Commission (SEC) to say that the returns an asset made in the past don't mean that future returns will be the same. That's partly because many of them use past performance as part of their advertising campaigns.

Past returns can be a helpful metric when choosing assets. However, returns shouldn't be the only aspect an investor considers. Firms that manage assets have to inform you that all investments carry some risk, even those that are more "safe" or "successful."

Performance Is Open to Interpretation

The way a firm calculates past performance can be misleading. You might think it is growing, that profits are high, and that there is cash flowing all over the firm based on their reports. In reality, they might barely be making it.

Much of the time, investors themselves are the ones that cause prices to rise and fall. More often than not, they trade at the wrong times, letting their emotions control their decisions. They buy more during rallies and sell more during slumps. If there appears to be a downward trend on the horizon, many begin to panic.

If you're trying to build wealth, that is a losing strategy. Once you've factored in inflation, you're likely to see a loss even if you have a few percent gain. If you do not see returns that are higher than the rate of inflation, you're losing money.

Hockey star Wayne Gretzky summed up his secret to success. He stated that a good player must "go where the puck will be, not where it is." When analyzing a company or mutual fund, many people would do well to heed the same advice.

Instead, they begin "performance chasing" or "chasing the bull." As soon as they hear of some other asset class or sector having better short-term returns, they pull their money out of their other investments and pour it into the new list of someone's "Best Stocks for the Year," a headline seen everywhere.

Performance Changes Often

Past returns can be helpful when analyzing a stock or fund. The most vital action you take will be that you think about it with a long time horizon. If a stock goes up 15% in one year, you don't know whether it is a good investment now. It doesn't tell you whether it will be good in the future. It only tells you what it did over that one-year period.

However, if a stock has shown average annual returns of 9% for more than 40 years, it's a good sign. No one can promise you anything about that stock. But a stock that has made it through 40 years of market ups and downs can certainly offer insight into a stock's future growth.

When analyzing past returns, it's best to ignore returns from only the past few years. Try to focus on 10 years or more of returns.

Questions You Should Ask About Past Performance

How can you protect against jumping into a hot sector, fund, stock, or asset class? If you're looking at an investment, pause and ask yourself a few questions. Taking the time to answer these questions could help you protect yourself from making a decision based on emotions:

• What makes me think this company's earnings will be higher in the future than they are now? If there's little or no chance of growth, why do I need to invest right now?
• If I believe the company will grow, what are the risks to my hypothesis of higher earnings? How likely is it that these imagined risks will become actual realities? What are the worst things that can happen for this asset or fund?
• Why did a company not do well or do too well in recent years?
• Has this sector, industry, or stock had a rapid increase in price in the last few months? If so, why do I think it will continue to grow this fast?
• Am I buying or selling based on the asset's value, making systematic purchases, or am I trying to time the market?
• If there has been a major deviation from the mean, what makes me think it won't revert? How do I know that this truly is the new normal?