If you’ve ever spoken to an investment advisor who works for a bank, the odds are they showed you charts with the past performance. This is done to show you that the funds are a “proven” winner and you should invest them. However, what they should really be telling you (but never will) is that past performance is not indicative of future results.
So where does the line “past performance is not indicative of future results” come from? It’s actually in every mutual fund prospectus or investment disclosure. The reason it’s included is so investors understand that past results don’t guarantee future results.
Seems odd right? Investment advisors use past performance to sell you product, yet all the disclosure documents say it’s not a good reference. Advisors use the positive information to help make a sales pitch, but here’s an explanation of why you shouldn’t blindly trust that information.
Does past performance really not matter?
Many new investors have a hard time grasping the concept that past performance is not indicative of future results. If certain funds have been doing well over the last few years, that must mean the fund managers know what they’re doing right?
Sure, you could look at it that way, but it’s still a crapshoot. In Andrew Hallam’s book, Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School, he explains that there are five factors that reduce the returns of actively managed US mutual funds.
- Expense Ratios
- 12B1 Fees
- Tradings Costs
- Sales Commissions
Not all of these factors apply to Canadians, and to be fair, some fees have been reduced or eliminated, but that doesn’t change the fact that these factors cut into the return of mutual funds.
The reason many people still look at past performance is because they don’t know what to compare it with. It’s actually quite simple, you want to compare the returns of mutual funds with the average return of a similar index.
Well it turns out that the average index ends up beating actively managed funds about 90% of the time. Yes, 10% of funds get higher than average returns, but what are the odds of you picking the right fund?
Why it’s okay to settle for average returns
If you built a diversified portfolio of index funds, you could reasonably expect average returns of roughly 6-9% a year depending on your asset allocation. As mentioned above, this beats out the returns of 90% of actively managed funds.
Investment advisors rarely talk about index funds because they don’t make them any money. In some cases, they might actually sell you a mutual fund that tracks an index, but charges you the higher management expense ratio. This greatly cuts into your returns and is one of the factors Andrew Hallam talks about.
Tracking indexes aren’t very sexy, but it’s a proven way to grow your portfolio. The best part about index funds is that you can invest in them on your own, through a robo-advisor, or with Tangerine Investment Funds.
I realzie I’m simplifying things quite a bit, but the above links should give you enough reference material to give you the basics of index investing. You should also check out the Canadian Couch Potato website which is the ultimate source for Canadian index investing.