As market investors, we’ve all come across the cautionary warning “Past performance is not indicative of future returns”. So why is past performance not indicative of future returns? If not future returns what else can past performance speak towards? In this blog post, we dig deeper.
As market investors, we’ve all come across this cautionary warning multiple times.
“Past performance is not indicative of future returns”
Winners will continue to be repeated in the markets seems obvious, with every investment advertisement beaming with last year’s returns. However, like many other things advertisements tell you, this is neither obvious nor true. So why is past performance not indicative of future returns? Let’s dig deeper.
The performance of investments fluctuate from year to year. An investment going up 50% in one year says nothing about its returns in the upcoming year. It could be a result of significant market movements or because of substantial restructuring within the company. This could mean that a fluctuation leads to an investment decreasing in value when you need the money the most.
Here’s an illustration of how bad a market fluctuation could be:
This will help you visualize that over 2 years some of the world’s most consistent funds and companies have experienced significant fluctuations. Parking your savings in assets subject to market risk may mean that you will not be able to access your funds when you need them. You should avoid investing in any stock, mutual fund, or ETF for a short holding period as such fluctuation may affect having access to funds for personal use.
Make sure you protect your investments from fluctuations as you get closer to your goals (known as Glide Path). Pull your investments into less fluctuating asset classes in advance of your goal timeline to protect your investments.
Now that we know that while we can use past performance to get deeper insights into a fund or company, we shouldn’t be basing our investment strategies purely on past performance but instead using it as one among many metrics to look at a fund’s suitability.
Your holding period, the duration or period of staying invested, matters. A common way to know your timeline is to lay out your expected financial goals in the short and long term. Once you know how long you can stay invested, you will be able to better identify an investment opportunity that does not significantly fluctuate in that period.
An asset class is a grouping of all instruments that exhibit similar characteristics and follow the same laws. Equities, cash and cash equivalents, real estate, commodities, and currencies are typical examples of asset classes. Once you know your holding period, look at past performance data to identify which asset classes meet these criteria –
Dollar Cost Averaging is the practice of systematically investing equal amounts of money at regular intervals. It can reduce the overall impact of price fluctuations. Once you have identified consistent performers, invest in them regularly (like a Systematic Investment Plan or SIP).
Before you decide where to invest and how much to invest, we help you articulate your goals and build your financial game plan. We make it simple for you to find your holding period. With wealth42, we take care of all of the hard number crunching. All you need to do is enter your goals, and we’ll help you find your investment horizon with asset classes that match your goals and lifestyle!
