Past performance is no guarantee of future returns - The Hyperion Effect

It’s a sentence that you see everywhere there is a financial investment mentioned. It is attached to presentations, T.V. shows, advice documents and e-mails. Pretty much anytime you speak to a financial professional who recommends you invest into something you will see the words ‘Past performance is no Guarantee of Future Returns’ or some variation of it.

But have you ever stopped to think seriously about this statement?

If past performance does not guarantee future returns why do people stampede to put their money into the hottest fund of the moment or the trendy tech company who’s shares keep on going up because this time its different. If past performance did guarantee future returns then we would all be gazillionaires and there would be no financial services industry. We could just look at what did well last year and stick all our money in that……..But the reality is that the statement is very important and thats why it is there. Take a look at the chart below, which may initially blind you with its colors, but they are there for a very specific reason.

Each of the colors represents a different asset class including Large Companies, Small Companies, Value Companies, both Australian and International, along with Emerging Markets, Cash, Property and Fixed Interest. Have a really good look and tell me if you can see the pattern?……………………………

Give up yet? Well the answer is there is no pattern. The chart is sorted from highest to lowest and so if past performance did guarantee us future returns in 2001 all we needed to have done was put all of our money in the light blue asset and we would have been a winner. Unfortunately it was the third worst performer in 2001 and for the remainder of the decade never got back to number 1 or even past the 50th percentile.

Why am I writing about this?, well other than the fact that all investment strategies should have diversification built into them, I saw a segment on CNBC last week that bought the past performance statement into stark contrast.

Firstly, lets give credit where credit’s due, John Paulson generated some outstanding returns for himself and his investors when he correctly bet on the U.S. subprime collapse and then doubled down with foreseeing a surge in the Gold price in the aftermath. This made him somewhat of a celebrity due to the fortune amassed on these two bets. However things have taken a turn for the worse of late for Paulson and his investors with Reuters reporting in a recent article that his funds are down more than 30 percent this year, compared to a much smaller 6.1 percent decline for the average hedge fund. Paulson reportedly manages around $20 billion in ‘outside investor money’, a large proportion of which came into the fund after he became famous for making $15 billion on the subprime mortgage collapse, likely leaving them sitting on a large loss.

This pattern is repeated year in and year out as investors continue to naively chase this years winner in the hope of replicating the returns. I wrote about this in a recent post highlighting an article that discussed how the industry perpetuates this process through their ‘star’ rating system.

Past Performance is no Guarantee of Future returns but unfortunately, for many investors, they learn this lesson too late.

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