Investors approaching or in retirement should not take undue risks, either by chasing performance or being highly speculative. Advisors can add value by emphasizing the importance of long-term, goals-based performance.

There is no doubt that investors are attracted to positive performance. Unfortunately, most investors stop there and fail to perform the due diligence needed to confirm that the returns are meaningful. In most cases, they place entirely too much emphasis on performance without considering the context of the market or the ever-important philosophy behind their strategy.

Here’s a fact: All performance measures are based on trailing performance. Why do you suppose the National Association of Securities Dealers (NASD), the predecessor of FINRA, and the SEC established the requirement that the disclaimer “Past performance is no guarantee of future results” appear on all official documents and advertising? Because they knew that an advisor’s or fund manager’s performance is only a measure of how they did in the past, nothing more. Not surprisingly, the past can be significantly affected by many factors beyond the advisor’s or money manager’s control.

It is not unusual for investors to chase performance, as humans tend to extrapolate the recent past into the future. Our minds struggle with large numbers (see the article “A Different Perspective on Standard Deviation”). When confronted with complex information, we tend to simplify it by only looking at things that are in recent memory. While this is not abnormal behavior, it is a deficiency in our human makeup and a behavior that is not healthy for your investments.

This is why investors are usually bullish at market tops and bearish at market bottoms. It is also why the financial media continues to interview analysts who have often been wrong in their past appearances but sound convincing enough to be invited back. Of course, investors love to hear them because they tend to push all the right buttons, making investors believe these analysts can predict the future. I’m sure the analysts’ frequent appearances have nothing to do with the advertising dollars spent at the network. (Tongue firmly in cheek.)

Reading financial publications that list recent mutual fund performance feeds the illusion that you can identify the next “hot” performer. The reason most funds make the “top performer” list is because of financial events and long-term economic or market cycles that are totally out of the fund manager’s hands. These events usually have an effect on asset classes, which in turn have an effect on the funds’ performance.

A fund that is heavily loaded into a particular asset class will generally perform like that asset class. Mutual funds are often ranked using stars, with more stars indicating outperformance relative to their peers. Some studies show that this ranking can also serve as a contrary opinion marker. I have looked at it in detail, and while the contrary part eventually works out, the time involved is usually much longer than most investors will tolerate.

Learn from the past, but focus on personal long-term, goals-based performance

The years 1998 and 1999 provide good examples of investors chasing performance. During that time, many dumped their money into technology issues (dot-coms) based solely on recent performance. Meanwhile, those who studied market internals and risk were generally in defensive positions for much of those years. Their performance suffered in the short term, but payback time was just around the corner. The excesses of the late ’90s began to pay their tuition in early 2000.

Those analysts and advisors who took defensive positions early became the top performers during the big bear market that ensued. Did they know the market was going to plummet? No, they just knew the risk of being invested was too high and acted accordingly. A similar thing happened in 2006–2007, and guess what: It will happen again.

Another common mistake investors make is failing to evaluate their own performance—whether in their retirement plan, individual brokerage account, or elsewhere. They focus on chasing the hot issues without considering whether their strategy is actually working. Most would find that chasing performance has hurt them considerably over the years. DALBAR—a company that conducts an annual study on mutual fund investors’ performance compared to a large array of asset classes—consistently shows that individual investors, often due to frequent asset shifting, underperform the broader asset classes.

So, what should an investor do? Assess your needs over a long-term horizon. If you are amassing assets for retirement, you cannot take undue risks, either by chasing performance or being highly speculative. You must adopt the mindset that long-term performance is what you need to reach your goals.

This is easier said than done.

The really lucky folks are the ones who find a good advisor—one they are comfortable with, who has a long-term record of avoiding big risks while still achieving satisfactory returns, and who takes defensive positions in bad markets. Those investors enjoy a good night’s sleep. And it is not about outperforming your friends and neighbors. An investor’s satisfactory performance is personal—period.

Invest by knowing the past but not expecting it to continue ad infinitum.

The opinions expressed in this article are those of the author and the sources cited and do not necessarily represent the views of Proactive Advisor Magazine. This material is presented for educational purposes only.

This article by Greg Morris, originally titled, “Past Performance is no Guarantee of Future Results,” was first published at StockCharts.com on Oct. 12, 2022. Many thanks to the author and StockCharts.com for permission to republish an edited version of the article. Please see many commentaries by Mr. Morris on the blog Dancing with the Trend.