Investing in the rear view mirror

21st May 2008

When picking investments, people tend to rely on past performance figures to make their decisions. Those funds that sit at or near the top of fund performance tables can look attractive for a number of reasons.

A fund that has delivered above average returns before surely stands a good chance of doing so again in the future?

The risk of following this approach to investing is that you will often 'miss the boat'. It is a bit like driving a car whilst continually looking in the rear view mirror.

Investing based on past performance gives you a pretty good idea of where the fund has been in the past, but it is a lousy method of determining where the fund will go in the future.

Any investment comes with the small print 'past performance is not necessarily a guide to future performance'. We see this risk warning so frequently with investments that it is easy to tune it out. However, the reality of investing lends weight to this small print and investors should pay more attention to that short statement when they invest their money.

Two investment events in recent memory are good examples of why this small print is so important.

Investors who rushed to buy into technology stocks in 1999 and 2000 were the biggest losers when the dot-com bubble burst. More recently we have seen people investing in commercial property in 2006 and early 2007, on the back of some very positive returns, and then lose large amounts of money when the value of this sector fell.

It is usually the case that a different investment sector provides the best returns every year. This means that what might provide the top returns this year is unlikely to do so again the following year. Because nobody can consistently predict which sector will outperform the others each year, the only really sensible approach is to invest your money in a well diversified portfolio with exposure to each of the different asset classes.

This approach, known in the investment community as 'asset allocation', tends to deliver more consistent returns in line with the level of risk you feel comfortable taking with your money. In fact, different academic studies have proven that asset allocation is the single biggest contributor to investment returns, ahead of other factors such as fund selection or market timing.

Making your investment decisions based on asset allocation, rather than fund selection alone, can remove a lot of the luck from the process of investing your money. It is something that can be applied equally as well to pension funds as it can to more traditional investments such as Individual Savings Accounts (ISAs).

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