Yesterday’s news
Steve Utkus, one of my fellow bloggers, wrote recently about the dubious value of a local radio station’s early-morning reports on where the S&P 500 and Nasdaq markets are likely to open the day, based on futures trading. He labeled it “junk news.”
Since this is a “summer of sequels” at the cinema, I’d like to add my own sequel to Steve’s blog post.
One of our local news stations has a daily feature on mutual funds that highlights the best-performing funds by citing their returns. Frequently, the funds are those that specialize in particular sectors, and their performance is ranked for very short periods of time—usually year-to-date. I’m puzzled by the value, if any, the station’s listeners find in these reports. Is it purely informational (e.g., “That’s interesting; I didn’t know that”), or are people actually making investment decisions based on the report? While I hope it’s the former, I fear that some people may fall into the second group. I wonder what purpose this is trying to serve, and why the “truth in advertising” standards don’t apply here.
This raises a bigger question: Why broadcast fund performance at all? Publicizing a fund’s past performance is like selling yesterday’s newspaper. It’s of little value and provides no insight as to what the news may be the next day. (Now, if we could buy tomorrow’s newspaper today, that would be a different story!)
There are just too many variables to make past performance a reliable indicator of a fund’s future returns. Did the fund manager have a blow-out quarter (good or bad) that’s influencing the long-term numbers? Is a manager with skill being labeled a poor performer because he or she is burdened by a high expense ratio that depresses the performance?
All of this makes the purchase decision for funds that much harder. For many other purchases in our lives, past performance is a good indicator of future performance, whether it’s a car or a washing machine. Not so for investments.
Given the limited value of using past performance as a purchasing guide, how do you evaluate investments in your portfolio?
Note: All investments are subject to risk.
Past performance should be an indicator of where we are in the business cycle. This is especially true of a sector fund. If one follows the 10 principal sectors closely, it should become more obvious which one will be the next to rise. However, one must be fairly confident of which sector is currently prominent- it takes more than one mutual fund or ETF to verify where you are in the business cycle.
“Given the limited value of using past performance as a purchasing guide, how do you evaluate investments in your portfolio?”
I look for lowest expense ratios (VG index fund mostly), broad indexes for diversification and try to keep my asset allocation tuned to my risk level (sleep well at night factor).
I’ve come to realize that the future performance of my investment choices falls on me–not a manager.
Since the tech bubble, I have picked a well diversified set of low-cost index funds with a smaller complement of actively managed balanced funds for further diversification. However, these actively managed funds have a longer than 20-year track record of low beta and respectable returns.
“The past is not a sample of the future”. Every investor should understand the meaning of this statement and keep it in mind as they listen to the news.
Every investment is based on certain assumptions about the future. There are many good ways to develop these assumptions. Statistical analysis of past results is not one of them. The basic fallacy is that detailed statistical analysis assumes that that a set of past results is a sample, that it’s representative of the whole. You put in numbers, you get out numbers; always! Numbers generate a feeling of power and confidence. But the past is NOT a sample of the future. We know that sometimes a dartboard does as well or better. What are good ways to develop investment assumptions? Now that makes for a very good story. All I know for sure is that ignorance is expensive.
I’ve heard similar reports in the past and can’t help but think that return figures matter to one group of people - those who are already invested in said funds. To the person who isn’t, it matters not. Thanks for bringing this to public light, because up until now, I privately loathed such reports.
How do I evaluate investments in my portfolio?
I feel like an operator of a canoe facing backwards as I paddle on a very large lake. I can see clearly where I’ve come from and I can feel the waves I’m heading into but I can’t see what’s ahead. I know how long I’ve been traveling, but I don’t know how much longer the trip will take. I have some very important passengers with me, some of whom will continue their journey after mine is completed. I have supplies coming in and supplies being consumed. My greatest concern is that I have enough supplies to finish my trip, with some left over for my passengers. But it’s not my only concern. I have pride. I want to do well. There are lots of fellow boaters and guides offering me advice and supplies, most expecting to be paid, but the responsibility is mine alone. The only thing I’m sure of is that if I have more supplies coming in than going out, I’ll have enough to finish the trip.
For me the purest way to evaluate my investments is not the return reported by the fund, but the value on my statement from point to point. For example, assuming no additional principle investment, what was the value on Dec 31 of 2008 vs Dec 31,2009 - its really that simple. If I ended last year with $2000 and I end this year with $2400. I had a 20% paper return for the year. My goal is to maintain a return of 2-3% over what I could get with a bank CD. Looking back over 3 -5 years is helpful in deciding whether or not to make the investment to begin with, but I discount the results that go back further than about 5 years as there are too many variables that may have changed during that long of a “look back” period.
Evaluating funds this way is too superficial and tends to entice people to buy at the top. What would be a better indicator is consistency over the years, which requires more in depth comparison than an over the air show can provide.