Editor's note: Originally published on July 11, 2014
Every money manager must say that past performance is not an indicator of future results, but most investors ignore this warning. In fact, most investors--individual and professionals alike--use past performance to choose money managers.
That's a big mistake. S&P Dow Jones recently reported on why: investment performance is rarely persistent. Put differently, past performance really doesn't tell you much about future returns.
How bad are the numbers? Out of the 687 mutual funds that were in the top one-quarter in March 2012, only 3.8% were there again two years later (purely random results would have indicated 6.25% would have remained). Out of the 1,372 mutual funds that were in the top one-half in March 2012 , only 18.7% were there two years later (purely random results would have indicated 25% would have remained).
Just because a money manager beats the market in one period does not mean they will in the following period. In fact, it is much more likely they won't. Over 5 years, the numbers are even more stark. Out of 715 mutual funds in the top one-quarter in March 2010, only 0.3% were there again four years later (purely random: 0.4%). Out of 1,431 mutual funds in the top-half of in March 2010, only 4.5% were there again four years later (purely random: 6.25%).
Does that mean that no one can beat the market? No. Does it mean it is very hard for someone to do so? Yes. It is even harder to tell the difference between those who can do it persistently and those who can't.
Investors who use past performance to chose money managers are taking a huge risk.