Almost all of the U.S citizen knows that cigarettes are not suitable for the health, there is a statutory warning on every packet of cigarette which you pick.
But unlike so much knowledge about the health issues related to cigarettes, most of the U.S. citizen needs to know that picking up investments based on their past performances is not good for your wealth.
The most amazing thing here is that they don't know despite the fact that in any investment advertisement they can it is written there is that - "past performance does not guarantee future results'.
Many studies and surveys have been done in the past to understand why this disclosure is so ineffective, and lacking success. Below there is one such disclosure so that you can test the effectiveness of Disclaimers in Mutual Fund Advertisements:
'Mutual funds investors flock to funds with high past returns, despite there being, little, if any, relationships between the high past returns and high future returns.
Because fund management fees are based on some assets invested in their funds, however, fund companies regularly advertise the returns of their high-performing funds.'
There are many such studies published, which also shows that Mutual Funds Performance Advertisements: which is also inherently and materially misleading.
In one more experimental study, it was researched why-why does the law of one price fail?
One experiment was conducted on Index Mutual Funds; all educated investors were asked to pick among four S&P 500 index funds (in which investment was the same and in the same stocks).
And to the everyone's surprise participant shown very irrelevant statistics on the past performance which includes - inception to date return' and which was very useless statistics until and unless all the funds have the same starting date.
The right way to pick the fund would be to find the funds with the lowest fees, but still, about 95% participant picked up the wrong funds and never realized to minimize the fees.
Despite clear evidence, they have got the way of disclaimer that picking up the funds based on the past performance and this is not the right way to pick up the funds, but still people keep on doing it.
There can be many speculations for this significant confusion and one they can be selected when to pick the relevant past performance and how to decide when not to pick not irrelevant past performance, below we will see few guidelines which will guide to understand when to have use of the past performance:
Past performance related to the manager's expertise is not relevant:
As an investor, you should understand you should not judge the past performance based on the talent and expertise of the investment manager, maybe he got lucky in the past or having his unique style to make the investments for the more extended period.
But it does not mean that this will also favor you out. Studies show that the active managers are not that effective to earn returns more than the comparable index.
Past performance is irrelevant in you to compare it with different fund type:
If you start comparing the performance of the different fund, you won't ever get any relevant results, as comparing substantial cap funds with small caps and real estate funds with emerging market funds.
So, if you pick investments based on past performances, you will leave out your target as few asset classes me delivering well in last few years but don't mean they will continue to perform well for few years in the future.
Risk premiums expected returns are relevant over a long time duration:
Most of the occasions it is seen that the one more thing for which people get confused is past performance with expected returns which generated from risks premiums.
As most of the investors think that stocks with a long duration will perform well in comparison with safer investments like bonds. "Proof" which is the term mentioned with this reminding past performance.
But the thing to get clear here is that over time stocks should be considered here which are over time the things which you should consider is called - 'equity risk premium.'
You should use your common sense when evaluating the risk premium, Let's say you have invested $20,000 in your local bank and earning the risk premium of about 1%, and another thing which you can do with that $20,000 is that to invest in the business of your trusted friend.
But when you invest the money in the business that does not mean you should expect the profit of 1% and there seems to be no reason you would be doing this.
Common sense plays a significant role here as a business have all the chances to fail but if not naturally you will expect more than 1%.
This concept of risk premium it is evident that it will give higher returns to specific assets of classes. The expected returns from equity risk premiums obviously differ from opting the mutual fund or adopting a trading strategy based on past returns.
You can use the equity risk premium tool to build your portfolio of investments that have the higher expected return for a longer duration than various less risky options.
And when you start using equity risk premium method is entirely a different process to build your portfolio than evaluating the list of mutual funds, and opting for the one which has generated a high rate of returns over last few years may be up to ten years or inception to date period.
So you should invest in a smarter way and have a good health stop using the dumb ways of comparing unrelated stocks and funds.
If you are still unable to find it tough to invest in a smart way you can always take help of professional investing expert.
Apparently, there will be fees for having advice but it will be worth than making any dumb investment.