Pursuing a Better Investment Experience (Part 2)

Welcome to the pursuing a better investment experience series. We are going to review two topic points regarding market performance facts, let’s get started.

The First Point – Resist Chasing Past Performance

Some investors select funds based on their past returns. Yet, past performance offers little insight into a fund’s future returns. For example, most funds in the top quartile of previous five-year returns did not maintain a top-quartile ranking in the following five years.

  • Some investors may resort to using track records as a guide to selecting funds, reasoning that a manager’s past success is likely to continue in the future. Does this assumption pay off? The research offers strong evidence to the contrary.
  • This exhibit shows that among equity funds ranked in the top quartile based on previous five-year returns, a minority also ranked in the top quartile of returns in the following five-year period.
  • A lack of persistence casts further doubt on the ability of managers to consistently gain an informational advantage in the market. Some fund managers might be better than others, but track records alone may not provide enough insight to identify management skills. Stock and bond returns contain a lot of noise, and impressive track records may result from good luck. The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed.

Let Markets Work for You

The Second Point – Let Markets Work for You

The financial markets have rewarded long-term investors. People expect a positive return on the capital they supply, and historically, the equity and bond markets have provided growth of wealth that has more than offset inflation.

  • Most people look to the financial markets as their main investment avenue—and the good news is that the capital markets have rewarded long-term investors. The markets represent capitalism at work in the economy—and historically, free markets have provided a long-term return that has offset inflation.
  • This is documented in the growth of wealth graph, which shows the monthly performance of various indices and inflation since 1926. These indices represent different areas of the US financial markets, such as stocks and bonds. The data illustrates the beneficial role of stocks in creating real wealth over time. T-bills have barely covered inflation, while longer-term bonds have provided higher returns over inflation. US stock returns have far exceeded inflation and significantly outperformed bonds.
  • Another key point is that not all stocks or bonds are the same. For example, consider the performance of US small cap stocks vs. US large cap stocks over this time period. A dollar invested in small cap stocks in 1926 would be worth considerably more today than a dollar invested in large cap stocks.
    Keep in mind that there are risks and uncertainty in the markets. Historical results may not be repeated in the future. Nevertheless, the market is constantly pricing securities to reflect a positive expected return going forward. Otherwise, people would not invest their capital.

Overall, the two key points to remember are:

  • Resist Chasing Past Performance and
  • Let Markets Work for You

This concludes the second video of the Pursuing a Better Investment Experience series. To learn more, check out our other videos!

Disclosures

This study evaluated fund performance over rolling periods from 2002 through 2021. Each year, funds are sorted within their category based on their previous five-year total return. Those ranked in the top quartile of returns are evaluated over the following five-year period. The chart shows the average percentage of top-ranked equity and fixed income funds that kept their top ranking in the subsequent period. Data Sample: The sample includes US-domiciled, USD-denominated open-end and exchange-traded funds (ETFs) in the following Morningstar categories. Non-Dimensional fund data provided by Morningstar.

Dimensional fund data is provided by the fund accountant. Dimensional funds or subadvised funds whose access is or previously was limited to certain investors are excluded. Index funds, load-waived funds, and funds of funds are excluded from the industry sample.

Morningstar Categories (Equity): Equity fund sample includes the following Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Global Real Estate, Japan Stock, Large Blend, Large Growth, Large Value, Mid-Cap Blend, Mid-Cap Growth, Mid-Cap Value, Miscellaneous Region, Pacific/Asia ex-Japan Stock, Real Estate, Small Blend, Small Growth, Small Value, World Large-Stock Blend, World Large-Stock Growth, World Large-Stock Value, and World Small/Mid Stock.

Morningstar Categories (Fixed Income): Fixed income fund sample includes the following Morningstar historical categories: Corporate Bond, High Yield Bond, Inflation-Protected Bond, Intermediate Core Bond, Intermediate Core-Plus Bond, Intermediate Government, Long Government, Muni California Intermediate, Muni California Long, Muni Massachusetts, Muni Minnesota, Muni National Intermediate, Muni National Long, Muni National Short, Muni New Jersey, Muni New York Intermediate, Muni New York Long, Muni Ohio, Muni Pennsylvania, Muni Single State Intermediate, Muni Single State Long, Muni Single State Short, Muni Target Maturity, Short Government, Short-Term Bond, Ultrashort Bond, World Bond, and World Bond-USD Hedged.

Index Data Sources: Index data provided by Bloomberg, MSCI, Russell, FTSE Fixed Income LLC, and S&P Dow Jones Indices LLC. Bloomberg data provided by Bloomberg. MSCI data © MSCI 2022, all rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. FTSE fixed income indices © 2022 FTSE Fixed Income LLC. All rights reserved. S&P data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. US-domiciled mutual funds and US-domiciled ETFs are not generally available for distribution outside the US. There are no guarantee investment strategies will be successful. Past performance is no guarantee of future results.

In USD. US Small Cap is the CRSP 6–10 Index. US Large Cap is the S&P 500 Index. US Long-Term Government Bonds is the IA SBBI US LT Govt TR USD. US Treasury Bills is the IA SBBI US 30 Day TBill TR USD. US Inflation is measured as changes in the US Consumer Price Index. CRSP data is provided by the Center for Research in Security Prices, University of Chicago. S&P data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. US Long-term government bonds and Treasury bills data provided by Ibbotson Associates via Morningstar Direct. US Consumer Price Index data is provided by the US Department of Labor Bureau of Labor Statistics. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. “Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. Please click here to read the full text of the Dimensional Fund Advisor Disclaimer.

About the Author Doug Finley

Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.

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