Enrich Your Future 13: Past Performance Is Not a Predictor of Future Performance

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 13: Between a Rock and a Hard Place.LEARNING: Past performance is not a strong predictor of future performance. “If you must invest actively, find active funds that design their strategies more intelligently to take advantage of the problems and at least avoid pitfalls.”Larry Swedroe In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 13: Between a Rock and a Hard Place.Chapter 13: Between a Rock and a Hard PlaceIn this chapter, Larry illustrates why past performance is not a strong predictor of future performance.Academic research has found that prominent financial advisors, investment policy committees, and pension and retirement plans engage top academic practitioners to help them identify future managers who will outperform the market. Such entities only hire managers with a track record of outperforming. They analyze their performance to see if it is statistically significant.However, research also shows that, on average, the active managers chosen based on outstanding track records have failed to live up to expectations. The underperformance relative to passive benchmarks invariably leads decision-makers to fire the active manager. And the process begins anew.A new round of due diligence is performed, and a new manager is selected to replace the poorly performing one. And, almost invariably, the process is repeated a few years later. So whenever pension plans interview Larry and he notices this hiring pattern, he always asks them what their hiring process is and what they’re doing differently this time since, you know, the same process failed persistently, causing regular turnover of managers. Nobody has ever answered that question.According to Larry, many individual investors go through the same motions of picking a manager and end up with the same results—a high likelihood of poor performance.Doing the same thing over and over expecting a different result is insanityLarry observes that the conventional wisdom that past performance is a strong predictor of future performance is so firmly ingrained in our culture that it seems almost no one stops to ask if it is correct, even in the face of persistent failure. Larry wonders why investors aren’t asking themselves: “If the process I used to choose a manager that would deliver outperformance failed, and I use the same process the next time, why should I expect anything but failure the next time?”The answer is painfully apparent. If you don’t do anything different, you should expect the same result. Yet, so many investors do not ask this simple question.Larry insists that it is essential to understand that neither the purveyors of active management nor the gatekeepers want you to ask that question. If you did, they would go out of business. You, on the other hand, should ask that question. You must provide the best returns to yourself or to members of the plan for which you are a trustee, not to give the fund managers or consultants a living.Break the cycle of repeating past mistakesLarry urges investors to reconsider their approach. The odds of selecting active managers who will outperform on a risk-adjusted basis over the long term are so poor that it’s not prudent to try. However, it doesn’t have to be that way. Investors would benefit from George Santayana’s advice: “Those who cannot remember the past are condemned to repeat it.”Anyone who insists on hiring active managers should look for a manager with low costs, low turnover, no style drifting, systematic strategies, and broad diversification (i.e., investing in a wide range of assets to spread risk). You are better off trading with a fund that owns hundreds of stocks because that narrows the dispersion of outcomes, which means you’re taking less risk.Further readingHerman Brodie and Klaus Harnack, “The Trust Mandate,” (Harriman House, 2018).Howard Jones and Jose Vicente Martinez, “Institutional Investor Expectations, Manager Performance, and Fund Flows,” Journal of Financial and Quantitative Analysis (December 2017).Amit Goyal and Sunil Wahal, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” Journal of Finance (August 2008).Tim Jenkinson, Howard Jones, and Jose Vicente Martinez, “Picking Winners? Investment Consultants’ Recommendations of Fund Managers,” Journal of Finance (October 2016).Did you miss out on the previous chapters? Check them out:Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and BondsEnrich Your Future 02: How Markets Set PricesEnrich Your Future 03: Persistence of Performance: Athletes Versus Investment ManagersEnrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?Enrich Your Future 05: Great Companies Do Not Make High-Return InvestmentsEnrich Your Future 06: Market Efficiency and the Case of Pete RoseEnrich Your Future 07: The Value of Security AnalysisEnrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market ReturnEnrich Your Future 09: The Fed Model and the Money IllusionEnrich Your Future 10: You Won’t Beat the Market Even the Best Funds Don’tEnrich Your Future 11: Long-Term Outperformance Is Not Always Evidence of SkillEnrich Your Future 12: When Confronted With a Loser’s Game Do Not PlayAbout Larry SwedroeLarry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored...