Investment decision-making: Avoid shortcuts
07 August 2018 | Portfolio construction
How do you go about choosing a restaurant, a new car or, or a dishwasher? Chances are you begin by looking online at consumer ratings and asking friends for their opinions.
Understandably, we look for shortcuts when making decisions and a common shortcut is to assume that past performance will continue in the future.
Certainly, it makes sense when buying a new vacuum cleaner to place weight on rankings for past reliability and the past experiences of other consumers.
Because the decision-making shortcut of relying heavily on past performance works well in most areas of our everyday lives, it is understandable that many investors would apply the same shortcut to buying and selling investments.
A Vanguard research paper, Reframing investor choices: Right mindset, wrong market, emphasises that the decision-making shortcut of relying too much on past performance "often falls short when it comes to making investment decisions".
While past performance can have some predictive value with non-financial decisions, the link between past and future investment performance is "tenuous at best", the paper emphasises.
To highlight the trap of relying on past performance when making investment decisions, other updated Vanguard research looks at performance of actively-managed Australian share funds over two consecutive five-year periods.
The majority of once top-performing funds for the first five years (ending December 2012) did not remain in the first quintile for the second five years (ending December 2017). However, if past performance was a reliable guide to future performance, most of the once first quintile funds could be expected to remain top performers.
Flows of capital in and out of investments suggest that a high proportion of investment cash flow is driven by past performance. "Momentum investors", as they have been called, buy investments when prices are rising and sell when prices are falling. In other words, they are driven by past performance.
Further, the top-performing asset classes often do not remain the top performers in the next year.
How can you try to avoid basing your investment decisions on past performance?
"First and foremost, one must recognise and understand that the decision process that serves well in most areas of decision-making does not work in investing," Vanguard’s paper on reframing investment decisions comments.
It suggests that investors shift their focus from past performance by relying on a straightforward, four-part decision-making process.
These steps are: develop a long-term financial plan to reach clear and appropriate goals, create a broadly-diversified portfolio across asset classes, minimise investment costs and periodically rebalance your portfolio.
Rebalancing a portfolio keeps it in line with its strategic asset allocation and is a disciplined way to respond to changing market prices.
Investors often assume that an investment that has outperformed in the recent past will continue to do well. And they often assume that an investment that has underperformed in the recent past will continue to underperform. Both assumptions are unreliable.
Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.
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Robin Bowerman, Head of Corporate Affairs at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.