The Pitfalls of Relying on Past Performance…
Monday 8 July, 2024
On every financial disclaimer, it is written that ‘past performance does not indicate future success’ but behavioural biases may lead one to believe otherwise; after all, if an investment has performed well in the past, why wouldn’t it continue to do so in the immediate future? However, financial markets are far more complex and dynamic.
Below we explore why relying on past performance can be misleading and how understanding this can lead to more informed investment decisions.
The complexity of financial markets
Financial markets are influenced by a multitude of factors – economic conditions, political events, technological advancements, sentiment, and even natural disasters. These factors interact in unpredictable ways, creating a constantly changing environment and different investment regimes. For instance, a fund that performed exceptionally well during a period of economic growth might struggle during a recession. The 2008 global financial crisis serves as a perfect example. Investments that had consistently delivered strong returns up to that point suddenly plummeted, fundamentally altering their future prospects.
Historical bubbles and crashes
The dot-com bubble of the late 1990s is a further example. Technology stocks soared as investors rushed to invest in internet-based companies. Although, when the bubble burst in 2000, those same stocks crashed. Investors who assumed that the past rapid growth would continue indefinitely faced significant losses. Companies like Pets.com, once market darlings, collapsed almost overnight, demonstrating that past success is no shield against future volatility.
Changes in individual companies
Individual companies can undergo changes that affect their future performance. Management changes, new competition, or shifts in consumer preferences can drastically alter a company’s fortunes. Consider Nokia, which dominated the mobile phone market in the early 2000s. Despite a history of strong performance, it failed to keep pace with the innovation brought by smartphones and subsequently lost its market leader position to companies like Apple and Samsung. Investors relying on Nokia’s past performance would have missed the critical inflection point where its future prospects changed.
The role of market sentiment
Market sentiment plays a crucial role in investment performance. Sentiment can be influenced by factors such as media coverage, investor mood, and social trends. The meme stock bubble is an example of this. Their stock prices surged, driven by speculative frenzy, only to retrace those gains once investor sentiment changed. This has an impact at a fund level – highlighted by the below performance data. Both funds were in top percentile of performers in their sector in 2020 but then went through two years where they were ranked anywhere between the fourth bottom and bottom percentile.
| Percentile rank | 2020 | 2021 | 2022 | 2023 | YTD |
| Fund X | 1 | 99 | 96 | 99 | 99 |
| Fund Y | 1 | 98 | 99 | 16 | 95 |
Source: Morningstar
Building a resilient investment strategy
Understanding that past performance doesn’t guarantee future results is essential for building a resilient investment strategy. Diversification, risk assessment and a focus on long-term goals and investment ideas rather than short-term gains are crucial. By spreading investments across various asset classes and sectors, investors can mitigate the impact of poor performance in any single area. Regularly reviewing and adjusting the investment portfolio in response to changing market conditions ensures that the strategy remains aligned with investment objectives.
Fundamentals and market timing
When thinking about a stock’s fundamentals, a company may experience a period of robust earnings growth, but this improvement might not be immediately reflected in its share price. Market participants can be slow to react, or broader market conditions might overshadow the company’s individual success. Over time, as more investors recognise the company’s strong performance, the share price may start to rise, aligning with the earnings growth. Conversely, there are instances where share prices rise ahead of earnings due to speculative behaviour, only to correct later when fundamentals do not support the inflated prices.
Conclusion
In conclusion, while historical data can provide valuable insights, it should not be the sole basis for making investment decisions. The drivers behind stock performance are ever-changing, and a strategy rooted in flexibility, diversification, and continuous assessment is far more likely to withstand the test of time. Lonsdale’s investment managers at LGT are forward-looking in their investment approach. This perspective often means identifying opportunities that others may overlook, including investments in funds that haven't just had strong short-term performance. By focusing on future potential rather than entirely on past performance, we aim to uncover value where others may not see it, positioning our portfolios to benefit from emerging growth opportunities.
Adviser insight
Stewart Sims-Handcock, Financial Adviser in Ringwood, emphasises:
“Investors should be cautious about making decisions based solely on historical returns. Markets evolve, and what worked yesterday might not work tomorrow. A diversified, forward-looking approach is essential for navigating the complexities of today's financial landscape.”
If you would like advice on investment vehicles, speak to our local financial advisers. If you are new to investing, we recommend you read our Beginner’s Guide to Investing. If you are looking for local financial advice call our offices in Wimbledon, Barnet, Leeds / Bradford, Stafford, Ware, Chippenham, Ringwood, Harpenden, St Albans.
Investment Risks: The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and customers may not get back the full amount invested. Views and opinions are based on current market conditions and are subject to change. This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Past performance is not a reliable indicator of future performance.
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