Investment decision-making: avoid shortcuts

How do you go about choosing a restaurant, a new car or, or even a dishwasher? Chances are you begin by looking online at consumer ratings and asking friends for their opinions.

Understandably, we look for shortcuts when making decisions and a common shortcut is to assume that past performance will continue in the future.

Certainly, it makes sense when buying a new vacuum cleaner to place weight on rankings for past reliability and the past experiences of other consumers.

Because the decision-making shortcut of relying heavily on past performance works well in most areas of our everyday lives, it is understandable that many investors would apply the same shortcut to buying and selling investments.

A Vanguard research paper, Reframing Investor Choices: Right Mindset, Wrong Market, emphasises that the decision-making shortcut of relying too much on past performance “often falls short when it comes to making investment decisions

…the decision-making shortcut of relying too much on past performance often falls short when it comes to making investment decisions…

While past performance can have some predictive value with non-financial decisions, the link between past and future investment performance is “tenuous at best“, the paper emphasises.

To highlight the trap of relying on past performance when making investment decisions, other updated Vanguard research looks at performance of actively-managed Australian share funds over two consecutive 5-year periods.

The majority of once top-performing funds for the first 5years (ending December 2012) did not remain in the first quintile for the second 5years (ending December 2017). However, if past performance was a reliable guide to future performance, most of the once first quintile funds could be expected to remain top performers.

Flows of capital in and out of investments suggest that a high proportion of investment cash flow is driven by past performance. “Momentum investors“, as they have been called, buy investments when prices are rising and sell when prices are falling. In other words, they are driven by past performance.

Further, the top-performing asset classes often do not remain the top performers in the next year.

How can you try to avoid basing your investment decisions on past performance?

First and foremost, one must recognise and understand that the decision process that serves well in most areas of decision-making does not work in investing,” Vanguard’s paper on reframing investment decisions comments.

It suggests that investors shift their focus from past performance by relying on a straightforward, four-part decision-making process.

These steps are:

  • develop a long-term financial plan to reach clear and appropriate goals,
  • create a broadly-diversified portfolio across asset classes,
  • minimise investment costs and
  • periodically rebalance your portfolio.

Rebalancing a portfolio keeps it in line with its strategic asset allocation and is a disciplined way to respond to changing market prices.

Investors often assume that an investment that has outperformed in the recent past will continue to do well. And they often assume that an investment that has underperformed in the recent past will continue to underperform. Both assumptions are unreliable.

WANT MORE INFORMATION?

Speak to us about how we can assist you to secure a bright financial future for you and your family by contacting Fionne McKillop at McKillop Financial Planning on (02) 9542 2904 or email fionne@mckillopfp.com.au

Fionne McKillop is principal financial planner at McKillop Financial Planning and owns her own law firm McKillop Legal, which is expert in estate planning, business succession and commercial law.

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This article was prepared by Integrated Planning Systems Pty Limited ABN 21 051 429 184 trading as McKillop Financial Planning, an Authorised Representative of GWM Adviser Services Limited ABN 96 002 071 749 trading as MLC Financial Planning, Australian Financial Services Licensee, 105 – 153 Miller St, North Sydney NSW 2060, a member of the National Australia Bank Group of companies. The information is current as at 01 November 2018.

The article does not take into account your personal objectives, financial situation or needs. Accordingly, you should consider how appropriate the information is to you with regard to your personal circumstances. You may wish to obtain an adviser’s assistance, tax and/or legal advice to make this assessment. Before buying any financial product, you should read the Product Disclosure Statement (PDS) for that product and consider the contents of the PDS before making a decision about whether to acquire the product.

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Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.

Source : Vanguard August 2018 

Reproduced with permission of Vanguard Investments Australia Ltd, via ClientComm

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