How much weight does previous performance carry when it comes to our investment decisions? Can we make our asset manager selections based purely on past returns?
Let’s consider the returns an investor would have achieved over the past ten years (January 2002 to December 2011) when investing in equity funds, but when employing five different strategies.
The red bar indicates the result an investor would have achieved by remaining invested in a composite portfolio of three quality equity funds for the entire ten-year period. The green and blue bars show the returns that would have been generated from remaining invested in a single fund for the entire period (the worst performing and best performing fund in 2001 respectively). The purple bar reflects the return that would have been earned had the investor, at the start of every year, moved his or her portfolio to the previous year’s best performing fund (effecting a total of nine portfolio switches). Conversely, the orange bar indicates the return that would have been generated had the investor moved the portfolio to each previous year’s worst performing fund instead.
So what does the data tell us?
This data shows it’s better to stick to your chosen investment strategy and remaining invested in a single fund or the same combination of funds over the medium to long term.
Consider that, in this example, you would have generated a higher return by remaining invested in the worst performing fund of 2001 than had you consistently switched to each subsequent year’s top performer. By trying to capitalise on previous performance you are basing your strategy on market events that have already transpired and are unlikely to duplicate themselves in an identical fashion the following year. In addition, portfolio switches generally come at a cost; product providers may charge a switch fee while your transaction may further attract Capital Gains Tax.
This is not to say that you can never change your selection of underlying investments, of course. If the funds you are invested in underperform consistently over prolonged periods, or your personal circumstances change, discuss the merits of switching funds with your financial intermediary.
However, jumping from fund to fund on an overly frequent basis may have a detrimental effect on your ultimate investment return.
Article continues on page two: can it be true that you'd be better off choosing the previous year's worst performing fund than choosing the one that performed best?