Why Investing Based on Past Performance Is a Terrible Idea

A paper published in 2020 by Yale’s James Choi and Kevin Zhao confirmed that investing based on past fund performance is foolish. They found that from 1994 to 2018, a fund’s performance was completely unpredictive of its future returns. “If anything,” Choi said, “over the past two decades, you seem to do a little bit worse if you chase past returns on mutual funds,” as compared to the performance of the average mutual fund.

Stocks

In any given year a diversified portfolio of stocks is going to contain some that generate positive returns, and some that generate negative returns. The presence of winners and losers is to be expected – in fact, it is unavoidable.

It may be tempting to try to improve the performance of a portfolio by eliminating stocks that have recently experienced negative returns. But screening out stocks based on recent poor performance is unlikely to produce positive investment results.

In 2020, the S&P 500 Index had a great year, returning 18.4%. Yet 199 of the stocks in the index – over a third – had negative returns for the year. Of those 199 stocks, 15 were removed from the index as part of S&Ps annual reconstitution, while 184 remained in the index. The remaining 184 “losers” had an average return of -16.4% in 2020.

In 2021, the S&P 500 Index returned 28.7%. Another great year. Of the 184 losers from 2020, only 26 had negative returns in 2021. Over 85% of 2020’s losers became winners in 2021. The average return of those 184 stocks in 2021 was +29.5%, beating the return of the index itself.

Over the last 40 years (1982-2021) investors who didn’t worry about screening out the losers would have done quite well. More than 400 stocks were removed from the S&P 500 Index during this period and hundreds of others experienced negative returns. Despite the presence of all these losers, the index grew a cumulative 10,131% and averaged +12.27% annually.

Industry sectors

We see the same thing if we analyze the S&P 500 Index based on industry sectors. In 2020, three of the 11 industry sectors represented in the S&P 500 Index had negative returns. They were financials -1.7%, real estate -2.2%, and energy -33.7%. Investors who screened those sectors out of their portfolios would have been sorry. Their returns in 2021 were financials +32.6%, real estate +42.5%, and energy +47.7%.

The same pattern was repeated in 2018 when the S&P 500 Index lost -4.38% overall and eight of its industry sectors experienced negative returns. The next year, 2019, all eight of those industry sectors experienced positive returns that averaged +29.69%.

From 2010 through 2021 there were 23 instances where an industry sector had a negative return. In only three of those did an industry sector have consecutive negative years. In most cases – 87% of the time – screening out a sector based on the previous year’s poor performance would have eliminated a positive performer and not avoided another down year.

A better way

Basing investment decisions on past performance is a bad idea. But there is one easy-to-use screening factor that is strongly correlated with higher future returns: fees and expenses.

Many studies have shown that funds with low expense ratios have a performance edge over funds with higher expense ratios. A 2010 Morningstar study tracked the performance of funds in different asset classes over various time periods. In every asset class over every period, the low-expense funds outperformed the high-expense funds.

Vanguard did a similar study using data through 2016 and came to the same conclusion – lower expenses and higher performance go together. On average, funds with lower expenses outperformed funds with higher expenses in all categories.

This outcome may seem counterintuitive in a world where we often associate higher cost with higher quality. But in an investment context it makes sense. Fees and expenses are a drag on performance. The more investors pay in fees and expenses, the less they put in their pockets.

Investors will be better off screening investments based on fees and expenses than past performance.

Scott MacKillop is CEO of First Ascent Asset Management, the first TAMP to provide investment management services to financial advisors and their clients on a flat-fee basis. He is an ambassador for the Institute for the Fiduciary Standard and a 45-year veteran of the financial services industry. He can be reached at [email protected].

Read more articles by Scott MacKillop