We tend to take shortcuts when making numerous decisions in our lives, such as choosing a restaurant or when buying a new car. But don't take shortcuts with investment decisions.
As a recent Vanguard research paper* observes, a common decision-making shortcut is to use a rating system based on the assumption that past performance will continue in the future.
It is hardly surprising that as this approach may seem to work for most everyday choices, investors are tempted to follow a similar decision-making process.
However, it is a fundamental trap to assume that past performance of an investment – whether good or bad – will continue.
The widespread reliance on past performance for making investment decisions is encouraged by the ready availability of past-performance data, often highlighted by commentators and fund managers.
And then there is the undue focus of many investors on short-term returns of individual investments and asset classes.
The flows of capital in and out of investments suggest that a high proportion of investment cash flow is driven by past performance data, including data entrenched in fund rating systems.
So, how can investors make better investment decisions?
The research paper's authors, who are members of Vanguard's Investment Strategy Group, put forward a four-part approach that moves away from a reliance on past performance to long-term planning.
Investors using this four-part approach to their decision making would:
Develop a financial plan to reach "clear and appropriate" goals.
Select a broadly-diversified portfolio across asset classes.
Minimise investment costs.
Periodically rebalancing their portfolio to keep it in line with its target or strategic asset allocation.
By taking this disciplined approach to making investment decisions, investors should become less vulnerable to being caught up with the prevailing investment moods that typically leads to buying when prices are high and selling when prices are low.
Financial planners can make a valuable contribution to the quality of investment decisions by encouraging investors to concentrate on long-term portfolio construction and goal setting – rather than on past performance.
Further reading: Vanguard's principles for investing success (recently updated).
* Reframing investor choices: Right mindset, wrong market by Francis Kinniry, Colleen Jaconetti, Donald Bennyhoff and Michael DiJoseph.
Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.
Reproduced with permission of Vanguard Investments Australia Ltd
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