As humans, we have a number of biases that can trip us up when it comes to money. When it comes to choosing investments, one of the more problematic biases is “past performance” bias, in which you make decisions based on the recent past of an asset.
Relying too heavily on past performance can make you too confident about an investment, or it can discourage you from investing in something you should consider.
Past Performance Doesn’t Guarantee Future Results
We hear frequently that what has happened with an investment in the past doesn’t guarantee that the same thing will keep happening. Just because an asset has been gaining doesn’t mean that it will keep doing so.
A number of investors get tripped up when looking at recent performance because they think that a stock or other asset will keep rising, just because it has been rising for a while now. Relying too heavily on immediate past performance can mean that you buy just as an asset is reaching its high point.
On the other hand, some investors think that the recent performance means that there are no more moves to be had. If a stock was at $20 a share four months ago, and is now at $35 a share, it can be tempting to think that the recent performance means that it’s played out. You might hesitate and hate to invest at that point. However, if the stock goes up to $50 over the course of another six months, you’ll miss out because your bias convinced you that the move was over.
It’s a tricky balance to strike when you are investing. Letting past performance bias cloud your judgment can mean that you put too much faith in volatile prices that are known for changing month to month — and even day to day.
Focus on Fundamentals and Funds Instead
Overcoming the recent performance bias and avoiding the pitfalls that come with it requires that you take yourself out of a position to rely on past results.
Instead of focusing on exclusively on performance, take a look at an investment’s fundamentals. What are the big picture items that contribute to its value (which is different from price)? When you pay attention to the fundamentals, rather than the technicalities associated with price changes, it’s easier to spot wider trends. You can get a better feel for whether or not an asset is going to move higher over time to overcome market volatility. Fundamental analysis can help you focus on the bigger picture, and the long-term potential of an asset.
An even easier way to break out of the past performance bias trap is to invest in funds. Index funds allow you take advantage of an entire segment of the market — or even the entire market. With an index fund, you don’t have to worry about individual performance. Instead, you get the benefit of the entire market’s movement. You don’t have to worry about recent performance because you will gain as the market gains.
Over time, many markets, as a whole, tend to rise. This is especially true of the stock market. In fact, the stock market has yet to lose, as a whole, in any given 25-year period. This means that, if you invest in an all-market index fund, you are likely to come out ahead over time. As long as you have a long time horizon, you can avoid the pitfalls that come with stock picking.
For the most part, overcoming the past performance bias is about taking a look at the big picture. The reality is that markets rise and fall. Markets are volatile in the short term. Over time, though, the volatility smooths out. You end up with a smoother trend line — one that slants upward — over the course of decades. Keep this in mind, and you will be less likely to succumb to any investment biases that might ruin your portfolio’s long-term results.