Why Past Performances Can’t Predict the Future

Key Takeaways

• Past performance does not necessarily equate to future results.

• When making decisions, investors must factor in variables such as market conditions, sentiment, and the possibility of chance.

• Understanding the limitations of past performance can help investors make better decisions.
  

While the past is not necessarily prologue, investors can different when it comes to such considerations. Rather than reflecting on a broad range of factors when making investment decisions, they sometimes rely exclusively on past performance. Too often, that results in poorer outcomes. Here is why past performance cannot predict the future, and how investors should manage their assets instead.

“Past Performance is Not Indicative of Future Results”

The above regulatory risk warning appears on nearly all investment materials, including prospects about mutual funds, equity investments, and even alternative investments. It is so ubiquitous that even those with only a passing interest in investing are familiar with it. In fact, the phrase also applies to various fields, including finance, sports, and business in general.

The problem is that many investors, for the most part, ignore the omnipresent proviso. Such investors apparently believe they can beat the system and make investments based solely on past results, when variables such as market conditions, the environment, investor sentiment, and the possibility of chance should also be factored in. After all, the stock market is inherently unpredictable.

The Limitations of Historical Performance

Going back decades, studies on mutual fund performances, for instance, show that past performance cannot consistently predict future performance due to the unpredictability of stock market prices. The issue is that while historic performance is worth considering, it can be misleading.

In fact, the market’s strongest performers tend to change every decade. Technology was the rage in the 1990s, and banks and commodities were hot in the early 2000s. That was followed by the growth of FAANG stocks in the 2010s.

The Importance of Portfolio Diversification

It has been established that past performance is not indicative of future results. Rather than rely on such performance to mitigate risk, a smarter move might be to make sure holdings are sufficiently diversified. To weather constant public market shifts, the smart move might be to supplement traditional assets with those that are not directly tied to the stock market. Such portfolios tend to grow over the long term despite short-term fluctuations.

The Sharpe Ratio

A widely used tool for measuring risk-adjusted returns, the Sharpe ratio compares an investment’s return with its risk. The mathematical expression was proposed in 1966 by economist William F. Sharpe and divides a portfolio’s excess returns by a measure of its volatility.

There are limitations to the ratio when used as sole criteria for investment decisions, however. For example, portfolio managers can manipulate it to fortify their risk-adjusted returns’ history by elongating return measurement intervals. That can result in a reduced estimate of volatility.

In addition, due to extreme herding behavior in financial markets, the standard deviation used to determine the ratio might underestimate tail risk – the chance of a loss occurring due to a rare event.

Exploring Alternative Investments

As will be discussed in detail later, alternative investments such as art and real estate are increasingly popular as vehicles for portfolio diversification. Essentially, they are any assets that are outside the categories of stocks, bonds, or cash. Largely unregulated by the Securities and Exchange Commission, they usually have little correlation to standard asset classes. Portfolios that include alternatives tend to continue to grow regardless of market conditions.

Neglecting Diversification

Failing to diversify one’s portfolio, or have an overconcentration of similar investments, can promulgate unnecessary risk.

An example of the consequences of not diversifying is the “lost decade” from 2000 to 2010, when the S%P 500 generated an annualized total return of 0.9%. It was just the second time – the other period was the Great Depression – the market had a negative overall decade-long return.

Despite turbulence caused by the collapsed dot-com bubble, two recessions, and the 9-11 terrorist attacks, a closer look reveals an over-reliance on very large-cap stocks when investing more in medium-sized stocks in the S&P 500 likely would have delivered better returns.

Is Relying on Historical Performance Really That Bad?

After all, one would return to a restaurant after a good experience and will likely again patronize a mechanic who did a good job on the transmission.

Really, historical performance can count – when looked at another way. While nearly every investment carries long-term growth expectations, prices can fluctuate. For example, a long-term expectation that the stock market will return 7% over the next decade does not equate to an expectation of an exact 7% return every year. That is because there will be fluctuations.

Still, the warning “past performance is not indicative of future results” serves as a reminder to investors to consider a host of variables when deciding how to allocate funds.

In so doing, investors can avoid costly mistakes and adopt smarter predictive strategies including diversifying their holdings with assets that have no direct correlation to volatile public markets. Increasingly, investors are buying into alternatives to do just that.

Diversification through Alternatives

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

Today, platforms like Willow Wealth provide curated access to private markets for individual investors.

Investors can get started with minimum investments as low as $5,000 for their first investment (subject to certain exceptions). Willow Wealth offers a curated selection of opportunities across multiple asset classes, ranging from individual investments to diversified funds and automated portfolio solutions. While these investments carry risk, they open the door to opportunities across real estate, private credit, private equity, and more.

Join more than 500,000 members and start investing in private markets today at willowwealth.com.

In Summary

The bottom line is that past performance does not necessarily equate to future results. Investors who understand the limitations of past performance can make better decisions regarding portfolio management, which can lead to better strategies and outcomes. One such strategy could be diversification through alternatives.

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.