It sounds crazy. I know. A financial advisor telling you that performance doesn’t matter.
But in terms of understanding what you can and can’t control and what will really help you reach your financial goals, focusing on your portfolio performance is actually a trap…and a really good one. Let me explain.
It’s interesting that so much of the investment media and “sales strategy” of Wall Street focuses on investment performance when that’s seldom the reason why investors do not reach their goals. More often, it’s because they just didn’t take the time to identify their goals and understand whether they are attainable. As a result, many investors have no idea if they’re saving enough or are spending too much. So, the financial industry has built a good trap trying to convince you that investment performance is all that matters. Publications, ads, magazine headlines all tout past performance and highlight how great manager ABC has done … in the past. And at the bottom of each article or advertisement in small print is the disclaimer “past performance is not a guarantee of future results. “
Too often, investors fall into the trap of making bad investment decisions based on the performance of their portfolio. Here are four downsides of the performance trap:
- Past performance is seldom a reliable indicator of future performance. The evidence and academic research is clear on this: picking future winners based on last year’s victories is a huge challenge and an uphill battle. From 1993 to 2013, only one in five equity funds and one in six fixed income funds survived and outperformed their benchmark. Additionally, even past winners are likely to underperform in the future. (1)
- Performance is no substitute for a financial plan. Focusing on performance doesn't tell you if you’re on track to meet your financial goals. It’s one of many indicators to help guide you, but without a good financial plan, you have no idea if you’re heading in the right direction. You might be happy with your portfolio’s performance, but that doesn’t mean you are prepared to weather the storm –– and in financial markets, storms happen!
- The grass is always greener on the other side of the fence. If you focus on performance, then you’re naturally going to compare your portfolio to an index like the S&P 500. But an index is just a basket of securities that may or may not be appropriate for you to own. It’s not based on your goals or what you want to accomplish. So, you’ll end up comparing your portfolio to the S&P 500 and start wondering why your diversified portfolio is trailing the index. You shouldn't judge your portfolio by how it performs compared to an index or a benchmark. If you do, you are really setting yourself up for disappointment, financial stress and the tendency to do the next downfall.
- Changing horses in the middle of a race seldom produces a winner.
One of the biggest obstacles to reaching your financial goals isn’t your investment performance. It’s your behavior. According to a recent DALBAR study, investors as a group tend to underperform because they chase performance. They often buy investments that have recently performed well and sell those that have not – instead of sticking to a long-term plan. Overreacting to normal, short-term market volatility can get in the way of achieving your long-term financial goals.
If you focus more on what you can control, and less on performance, then you’re less likely to get caught up in the performance trap. And you’re more likely to reach your financial goals.
For solutions to this problem, read my blog entry: “Top Four Ways to Avoid the Performance Trap”
(1) The Mutual Fund Landscape, Dimensional Fund Advisors 2013