Do You Mainly Depend on Past Performance Before You Invest?

While investing in stocks, bonds and mutual funds, past performance becomes a strong input in making investment decisions.

Question, should keep on relying on it excessively or there are other indicators available to investors, on which they can rely on to make investment decisions.

Table of Contents:

1. While looking at past performance look at the future too
2. Should You Invest in Mutual Funds Based Only on Past Returns?
3. What are all the other factors to be considered before looking at the past performance?

• Diversify your portfolio
• Have a judicious mix of equity, debt and precious metal in your portfolio
• Factor in time diversification

While looking at past performance look at the future too

However, for a lay investor, it will not be easy, as the famous economist, John Keynes had said, in the long run we are dead.

As investment in stocks and mutual funds are normally long term, investors may use this indicator too to support their past performance data.

Past Performance is one of the factors to be considered before taking the investment decision and past performance is not the only factor to be considered.

In fact, past performance is not an indicator of future results, and relying only on it can lead to poor financial decisions.

Are you relying mainly or only on the past performance?

It is like looking at the rear view mirror and driving. You are headed towards a fatal accident .

Mutual fund ads also carry a disclaimer that “past performance is not indicative of future results.”

This means that even though past returns give some perspective, they don’t guarantee the same outcome in the future.

Should You Invest in Mutual Funds Based Only on Past Returns?

This is one of the most common mistakes retail investors make. Many investors choose a mutual fund simply because it has delivered high past returns.

But remember: past performance is not an indicator of future results.

A mutual fund may have given 20% CAGR in the last 3 years, but that does not guarantee the same performance in the next 3 years.

Market conditions, sector trends, interest rates, inflation, and government policies all change with time.

Instead of only chasing funds with high past performance, investors should also check:

• Consistency of returns across different market cycles
• Risk-adjusted performance (did the fund take higher risk to deliver those returns?)
• Expense ratio and costs that eat into your long-term wealth
• Fund manager’s track record and investment philosophy

This way, you make a balanced decision, not a decision based only on history.

What are all the other factors to be considered before looking at the past performance?

Diversify your portfolio

There is an old saying. Never put all your eggs in one basket. In today’s risk management language it is called concentration risk.

In fact, in banks, concentration risk is considered one of the most important credit risk factors for the bank.

Reserve Bank of India, as a policy measure, have recommended banks to strictly follow exposure norms, i.e., not to lend a borrower or a group of borrower or in a particular industry or business or financial instrument or geographical location beyond a certain percentage of the capital of the bank.

Investors may take an important lesson from this guidance of the Reserve Bank while deciding on the composition of their investment portfolio.

To spread the investment in to different segments of business, industry, types of instruments, and then may invest.

By diversifying, you avoid depending on the previous performance of a single stock or mutual fund, which again proves that past returns are not a guarantee of future returns.

Have a judicious mix of equity, debt and precious metal in your portfolio

If you are less than 40 years, you may have a mix of portfolio, where equity would be say 50%, Debt 30% precious metals and other investment 20%.

As you advance in age the equity portion will reduce and others should increase.

In India, the returns on equities in the last 40 years have outstripped far higher compared to all other investment options.

But, please remember, return on equity should be always expected in the long run.

Even here, one must remember that past performance of equities, though impressive, is not a guarantee of future performance.

Market cycles and economic conditions may change.

Factor in time diversification

Market or business cycles vary from industry to industry, business to business.

Also business cycles should be also factored in to for long term.

Longer the time period we take and more businesses or industries we diversify, the peaks and lows of business cycle even out.

Investors would definitely argue, if we only invest in the long run, what about short term fund requirements.

For short term investment bank FDs, and income funds are the best instruments.

For income funds you may check the duration of the income funds, and match the duration of the income fund with your investment time horizon.

Say if your investment time horizon is 1 year you may choose an income fund with duration of approximately 1 year.

You need to diversify your investments across different time horizons like long term, medium term, short term, and ultra-short term.

So that your portfolio will participate in different stock market cycles and interest rate cycles and generate better return by reducing the overall risk.

This approach balances the risk of relying solely on past results, because past investment performance is not always indicative of what will happen across different time horizons.

To neutralise the over dependence on past performance of your stocks/ bonds/ mutual funds, the above options will be helpful to give a good return on your investments while minimising the associated risks.

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