Overreliance on ‘past performance’ can send you down the wrong path
Dear Dan,
Near the end of your article about Roth catch-up contributions, you suggested, “This is a good time for participants of all income levels and all ages to reassess their retirement plans.”
I’ve never really paid attention to my plan, so I started that process. My question is: With some investment options clearly returning more than others, why would anyone use those weak funds?
—Just Wondering in Jacksonville
Dear Just Wondering,
I haven’t met anyone who has deliberately bought a weak fund. Often, the source of their unfavorable choice is a misguided reliance on past performance. I’ll give you an example based on actual funds of how easy it is to come to false conclusions based on performance numbers.
The return of Fund A was 17% better than Fund B’s over one year and Fund A’s three-year and five-year averages were 4.3% and 8.5% better than those of Fund B, respectively. Those differences are quite large, but what do they tell you?
Does this mean Fund A’s management is more skilled than Fund B’s management? Does it mean they were better at getting in before the market rose, or out before a drop? Does it mean they were better at identifying themes or trends in the market? Or picking more of the stocks that did well during those periods?
While any of those things are possible explanations for the differences in performance between two funds, the answer to all of those questions is “no.” Both Fund A and Fund B are “passively managed” funds. Neither management team makes any attempt to time the market, identify themes or trends or pick the stocks that will outperform.
The differences in performance are simply the result of the two funds tracking different asset classes. They are holding two completely separate pools of stocks.
You can be forgiven for thinking that after lagging by 8.5% per year for five years, the asset class Fund B tracks isn’t worth owning. Here again, past performance can lead to false conclusions. Long-term returns of Fund B are good.
A well-diversified portfolio holds multiple asset classes that are expected to perform well over time but not necessarily move in tandem. Inevitably, some asset classes will lag behind and funds investing in those classes will appear weak. However, by combining such asset classes together, the portfolio typically provides good results with less volatility. The stock-market ride becomes smoother, though still far from truly smooth.
Maintaining exposure to lagging asset classes has worked because the performance differences between classes can change quickly. Those numbers I gave you earlier were as of Dec. 31, 2024. Fast forward a year and Fund B outperformed Fund A by 35% in 2025. Further, by simply changing the end date on past performance by a mere 12 months, all of Fund A’s advantage disappears. Fund B did better over the 3 and 5-year time frames ending Dec. 31, 2025, by 1.5% and nearly 1% annually.
Almost every advertisement or information piece you see about investments will have some version of the disclosure statement: “Past performance is not a guarantee of future results.” This isn’t simply a “CYA” matter. Research clearly supports the statement.
One easy-to-access example is the Persistence Scorecard of the SPIVA report, which S&P Global Ratings first published in 2002. One of the consistent findings in report after report is that there’s a better chance of picking a fund that finishes in, say, the top 25% of its category over the next five years by simply choosing one randomly than by choosing one that was a top 25% performer over the last five years.
It is not that past performance is totally irrelevant. The problem arises when people read too much into prior results. When reviewing your options in your plan, it is important to grasp what each fund is doing with your money and the multiple characteristics of the fund — such as expenses, management style and asset class — not just what it did in the past.
If you have a question for Dan, please email him with “MarketWatch Q&A” in the subject line.
Originally published on MarketWatch. Read the original article here.