Financial Planning

Nobody’s Fool

It’s a mistake to heavily weight hypothetical past returns when performing due diligence.

This investor may benefit from backward-looking hypothetical returns, assuming the flux capacitor works in his Delorean time machine. Otherwise, probably not so much. Photo by Angela Weiss/Getty Images.

When you’re reviewing potential financial professionals, there are myriad factors to consider. Experience. History. Flexibility. Size. Complexity. Yet Wall Street has introduced a few over the years that muddy the water, complicate your research and offer no real, material insight into the acumen of an adviser or the strategy he, she or they plan to implement. In my view, hypothetical performance illustrations belong on this list of investment Trojan horses.

It is a common sales tactic across the industry to show prospective clients a selection of recommended funds or contracted money managers. The selection generally fills out what the industry calls a “style box”—covering Large Cap, Small Cap, US, Foreign, Value, Growth, etc. Typically, the financial professional will select funds or managers based on some sort of past performance criteria, maybe returns over the last five or ten years. They claim this is performing a service for you—“screening” for the best of the best. Then, they show you a complicated analysis (all built on backward-looking factors) and offer you access. They are, in essence, doing one aspect of due diligence for you.

This screening effectively assumes past returns indicate future results, a fallacy underlying many behavioral flaws and investing errors. (For example, myopic loss aversion—the behavioral tendency for investors to fear losses much more than they appreciate equivalently sized gains—could be thought of as the presumption recent past losses indicate future negativity). Folks, ample evidence shows past returns alone won’t help you forecast or allocate. You must understand the how and why behind the numbers to see if they indicate much about the strategy and/or manager. Always remember, any investment decision—to buy, sell, hold, not buy, not sell—is inherently a decision about the future.

Standard and Poor’s publishes a report further illustrating this point. The Mutual Fund Performance Persistence Scorecard breaks down mutual fund trailing 12-month returns into four quartiles. In March 2009, S&P’s data show 558 top quartile US stock funds. One year later 88% of those funds were out of the top quartile. A year after that, only 4% remained. Flash forward to March 2013—five years from the start of the sample period—0.18% of the original 558 remained. Folks, if you do the math, that’s one fund. Point being, basing your choice on past returns is pure folly, yet these hypothetical performance analyses hinge nearly entirely on past performance.

But it’s worse! A hypothetical portfolio illustration may not indicate a strategy the financial professional was actually suggesting to clients at the start of the time period. Again, consider the rotation S&P’s data show—chances are next to none an advisor screening five years ago would’ve come up with today’s recommended top performing funds. In addition, you have to consider the strategy’s staying power. Even top-performing funds and managers have periods of lag. You have to wonder whether such a period would’ve changed the advice you were getting from your hypothetical purveyor. Or that they would have coached you not to panic when fear ran high! A hypothetical selection of funds or managers isn’t telling about the acumen of the financial professional whatsoever. Heck, it doesn’t even tell you if your advisor was in the industry five years ago.

Maybe some financial professionals just can’t show the performance of what they actually recommended or historically did. (There are myriad regulations governing investment professionals’ communications with the public, and some professionals would struggle to produce a historical performance figure that would comply due to, among many factors, the fact some employ many and varied different strategies.) I understand that. I was a financial advisor at one time. But that means the onus is on you, dear investor. You have to be conscious of the fact the returns you’re seeing may be flat out cherry-picked and not reflective of any actual portfolio performance.

If you have a time machine, by all means look to hypothetical portfolio construction and performance. Otherwise, you just might want to set it aside. I’m not suggesting you run when someone shows you hypothetical portfolios and returns. But in my view, this is not a useful input into your investment decision making. If your research aims to find the best possible steward for your portfolio, don’t be fooled by faulty, backward-looking comparisons to potentially fictional portfolios.

(As a further note, please note many online brokers dealing with clients who manage their own money also offer “screening” tools. They’re equally backward looking and may lead you into the faulty exercise of constructing a hypothetical portfolio on your own.)

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.