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By Dr. Jim Dahle, WCI Founder

Selecting investments solely by looking at past performance is the equivalent of driving while looking in the rear-view mirror. Sure, it can be done, but it probably isn’t going to lead to optimal results—and it might even lead to a spectacular crash.

This is known as “performance chasing” and is a well-known behavioral finance error that leads to repeatedly buying high and selling low. Yet most beginner investors do precisely this.

An example was posted recently in the WCI Facebook Group.

I was pleased to see that people in the group were very kind, and they lovingly helped this investor to see the error of their ways while providing lots of great education about returns, yields, and investment selection. But I thought this was too important of a topic to allow it to be buried in the depths of Facebook. This sort of thing happens all the time when people are asked to start investing. When does that occur? It occurs when they sign up for a 401(k) for the first time. They’re shown a dozen—or even worse, 50—different investments, and they are asked to select one or more in which to invest their hard-earned dollars.

For example, when I go into my partnership 401(k) to select investments, this is the screen I see:

That’s it. Just the names of the funds.

Now, this is a pretty darn good list of funds. If your list looks like this, you have nothing to complain about.

But most people don’t have this sort of a list. And in fact, if I click on one of the funds, it takes me to the Morningstar page for the fund, which has all kinds of useful information on it about the fund holdings, fees, and past performance. (Incidentally, that’s the order of information to look at when selecting funds.) But if you stay on the 401(k) website, all you can really learn about the funds is the current share price (useless information when selecting funds) and the past returns (almost useless information when selecting funds).

The performance looks like this: columns of returns including 1 month, 3 months, YTD, 1 year, 3 years, 5 years, and 10 years.

That’s the page most people see when they’re choosing funds for their 401(k). If that’s all the information you have (or look at), you’re, of course, just going to pick the things that have the highest past returns.

The Problems with Past Investment Returns

There are a number of issues that occur when you’re looking at past returns. The first one is that many sources don’t actually report them properly. Most investors don’t even know how to calculate their own returns, and a surprising number of investment managers don’t do it properly either. But many news sites aren’t even close to doing it properly. For example, they just report the change in share price and ignore all of the dividends. For example, if you Google “VTI” and look at the chart . . .

. . . You’ll see 17% returns. But if you go to the Vanguard website, you’ll see it’s reporting 19.2% returns for almost the same one-year time period. Why the difference? Well, there are actually two differences. The first is the Google chart was captured on the afternoon of February 2, and the Vanguard return was reported as of the end of the day on January 31. The market went up a fair amount in that day and a half, and maybe it didn’t go up that much from January 31-February 2 in 2023.

But the main difference is simply that the Google chart excludes dividends. If you exclude dividends, as so many news sources are apt to do, stock returns look significantly worse than they actually were, especially in the long run. This is precisely what the Facebook poster was doing. A chart was posted that only showed the change in the share price of the bond fund. That’s just silly when you understand that almost all of the return of a bond fund is from the income of the fund. Even when things are going pretty well, the price of the fund doesn’t go up much. In fact, the return on that particular fund over the last five years has been positive (0.85% per year on the day I’m writing this), not negative as the chart would suggest.

However, once you know you’re actually looking at the true returns, there is still a major issue with using them to decide how to invest. That problem is that you don’t have any plutonium to put in your flux capacitor.

You can’t go back and get those returns. They’re gone. And they’re really not very predictive of future returns, especially short-term returns. Don’t believe me? Spend a little time with the Callan Periodic Table of Investment Returns.

Each color is a different type of investment. Notice how there is a different color at the top of the chart every year. If you just bought what did the best last year, you’re going to have pretty rotten long-term returns.

There is likely a weak inverse correlation between short-term past returns and short-term future returns. The reason for this is obvious to the sophisticated investor. Short-term poor returns generally mean the price of the investment has declined. That means you’re buying essentially the same thing for a cheaper price. Just like you’d love to buy a hamburger and gasoline and that cute little skirt on sale, you should love to buy stocks, bonds, and real estate on sale. All else being equal,

• • When the price of high-quality bonds goes down, the yield goes up, and the best predictor of future bond returns is the current yield.
  • When the price of stocks goes down, the price-to-earnings (P/E) ratio falls, and you’re buying more company earnings with the same amount of money.
  • When the price of real estate goes down, the capitalization rate goes up, and even without any future price appreciation, your expected future return has gone up.

For any reasonable long-term investment, a lower price (meaning recent poor returns) typically increases expected future returns. There’s more to it than just “buying the dip” or buying the worst-performing investment you can find, but you certainly shouldn’t be scared off just because the investment has had poor returns for the last month, year, or even five years.

People are inappropriately reassured when they look at a five-year return chart and see good things and inappropriately scared when they look at a five-year return chart and see bad things. You’ve got to dive deeper. Why do those charts look like they do? What was different five years ago than today? If I were buying a total bond market fund today, I’d expect returns over the next five years to be something like 4.3% per year. But there can be a bit of a range. It could easily be 7% a year. It could also easily be 1% a year. If interest rates rise, that will likely result in lower returns than 4.3% (the current yield). If they fall, that will likely result in higher returns than 4.3%.

More information here:

The Nuts and Bolts of Investing

10 Ways to Console Yourself When Losing Money in the Markets

Know What You’re Buying

When it comes to investing, you need to understand what you are investing in and how it works in different economic climates. This will eliminate surprises and make it easier for you to stay the course with your long-term investing plan. Past performance numbers (especially very long-term past performance numbers like 20-30+ years) can be a useful part of the evaluation of an investment, but it’s not nearly as useful as novice investors think they are.

Physicians train for years to learn about medicine. But financial literacy was not part of the curriculum. That’s where The White Coat Investor comes in—by offering tons of entry-level information to get you started on the right path. We have a FREE email series called WCI 101 that reviews the basics in bite-sized chunks. You can check out our Start Here page to learn all about personal finance for doctors. And you can peruse our Frequently Asked Questions to get even more info. It’s easy to feel overwhelmed when learning about finance. WCI is here to help!

What do you think? Why do so many people invest while looking in the rear-view mirror? What can we tell them that will help them to stop?