Curing investors' fixation on past performance

David Peartree, BridgeTower Media Newswires

The most often repeated warning to investors is perhaps the most ignored: “Past performance is no guarantee of future results.” As a group, however, investors continue to act as if it did. Jason Zweig, the investment columnist for The Wall Street Journal, recently wrote about investors’ inability to kick what he calls the “past performance habit.”

Zweig points out that the current approach to convince investors to drop their reliance on past performance when selecting investment funds is generally futile and sometimes counterproductive. As Zweig says, it’s as if investors conclude, “well, if it’s no guarantee, then ... it must be pretty close to a sure thing.” Investors are stubborn in the face of information contrary to their beliefs, but facts are stubborn too.

One study cited by Mr. Zweig out of Santa Clara University found that the proportion of individual investors who expected stocks to rise over the next six months rose with every percentage point increase in the S&P 500 over the prior month. Taken alone, this study suggests some reliance by investors on past performance, but it is far from conclusive.

There is, in fact, a theory in finance which says that there is a tendency for rising asset prices to continue to rise and for falling asset prices to continue to fall. The momentum theory says that asset prices that have been rising or falling in recent months will tend to continue doing so for the next few months. However, these are short-term trends and do not make the case that past performance is predictive. Also, it’s doubtful how many non-professional investors are even aware of the momentum theory or are trying to employ it as a trading strategy. It is far more likely that many investors, as Zweig suggests, are simply hooked on past performance.

An older study from 2010 suggests that even more financially literate investors place undue weight on a fund’s long-term performance, even when presented with additional information that should lead them to a different conclusion. Several things about the design of the 2010 study were particularly noteworthy.

First, the subjects were, at least on paper, smarter than the average investor. The subjects included white collar Harvard staff employees, Harvard undergraduates, and MBA students from the Wharton School. Most of the employees had a college and an advanced degree. The MBA and undergraduate students boasted average SAT scores in the 98th and 99th percentiles respectively. All were tested and as a group were found to be above average in financial literacy.

Second, the subjects were incentivized to pick the best performing investment from among the choices offered. They were asked to allocate a hypothetical $10,000 among four real S&P 500 index funds. In addition to a stipend for participating in the study, the subjects were eligible for additional payments based on the actual performance of their chosen investment.

A third noteworthy feature was the use of index funds to test the subjects’ investment decisions. Index funds are essentially a commodity. All S&P 500 index funds aim to make their investment returns, before fees, match the S&P 500. Because they all aim to replicate the returns of the S&P 500, there is no reason to expect a fund with higher fees to outperform the others. All else being equal, the lowest cost fund should be the best performer.

A fourth noteworthy feature was the range of information provided to different sub-groups of the subjects and limited impact it had. All subjects received the statutory fund prospectus. In addition, some received one-page fact sheets detailing the expenses of each fund. Others received detailed FAQs explaining how index funds work and how they aim to match the benchmark returns before expenses. Others received more detailed comparisons of the historical returns for each fund. The additional information provided to different sub-groups of the subjects didn’t seem to significantly alter their focus on past performance.

The aim of the study was to find out why individual investors select high-fee funds, in this case, index funds. Notwithstanding their education, their incentives, and the range of information presented to them, the study found that “almost none of the subjects minimized fees.” As a result, almost none maximized their returns. Instead, the subjects focused primarily on a comparison of annualized returns of the available funds, particularly the returns since inception of the fund. Few subjects stopped to consider that measuring returns from different inception dates is not a meaningful comparison. It seems that disclosures can lead investors to water, but it can’t make them think.

The results of the 2010 study are consistent with other studies demonstrating how individual investors make suboptimal investment decisions. A 2019 study confirmed that the standard disclaimer about past performance did not help most investors make more intelligent investment decisions. It even found that among the least financially literate the repeated use of the standard disclaimer seems to reinforce the tendency to rely on past performance.

The 2019 study identifies two problems with the standard disclosure and suggests an alternative. The first problem is that telling investors that “past performance does not guarantee future results” does not break the link between past and future performance. If you tell investors that past performance does not “guarantee” future results, many will still infer that past performance is at least a high probability indicator.

The second problem is that investors may need an alternative cue to guide their behavior — something besides or in addition to a simple statement that past performance is not a guarantee of future results. The authors of the 2019 study suggest a disclosure that explicitly links lower fees with higher performance. They propose something along the lines of “funds with low fees have the highest future results.” Morningstar, a leading provider of investment fund analytics and commentary, has repeatedly stated that low fees, not past performance, are the single best predictor of future results. Why is that so? As Jason Zweig says, “performance is perishable, while fees are forever.”

The proposed language focusing on lower fund fees is probably an oversimplification, but the idea of presenting investors with a more useful form of disclosure — something that will break the fixation on past performance — is worth consideration.

Until then, investors would do well to remember another basic principle of finance — whatever current returns are, they are likely to gravitate to their long-term average. It’s called reversion to the mean.

John Bogle, the founder of Vanguard, was uniquely gifted in his ability to communicate financial concepts clearly. On reversion to the mean, he has this to say: “What goes up (above the market mean) must go down (below the market mean). This law of gravity — which affects all broad classes of stocks (large v. small, U.S. v. international, etc.) — is the classic manifestation of the eternal dynamics of the stock market’s extraordinary ability to arbitrage present reality against future expectations. Reversion to the mean may take place slowly or quickly; it may take place in spasms or over cycles; but take place it does.

Forewarned is forearmed.

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David Peartree JD, CFP is an investment advisor with Brighton Securities Capital Management. This column is a collaborative work by David Peartree and Patricia Foster, Esq. Patricia Foster is a securities law attorney with substantial experience advising members of the financial services industry. The information in this article is provided for educational?purposes and does not constitute legal or investment advice.