Exploring the Value of Historical Rates of Return
When investigating mutual funds as a suitable investment option, what most investors tend to do is look at the historical rates of return to determine whether or not that is something they might like.
While there are several inherent problems with looking at historical rates as a predictor of future returns, these returns certainly do provide value if they are observed in the right context.
To bring historical rates into a context that is both meaningful and valuable to the individual investor, the investor should: 1.
Compare historical rates against the investment fund's overall category.
This means comparing high yield funds against high yield funds and not generic fixed-income funds; not comparing domestic dividend funds against all domestic equity funds, etc..
While there could be some overlap in a fund's mandate, its security selection and how it generates income, comparing one fund that generates returns in one area against others that generate returns elsewhere will not be valuable at all.
However, comparing apples to apples (and not apples to fruits in general) will put those returns into a context that actually means something.
2.
Review the investment fund's total performance, not just returns.
This may seem odd on the surface, but if a fund has historically performed well but performance has changed in the shorter-term, determine what else changed in that same period.
Has management turned over? Has the fund's focus changed (e.
g.
from a value focus to a growth focus)? Has their top holdings concentration shifted? What changes might explain the shift in performance? In some cases, such a shift can alter the composition of the fund and transformed it into something one might want to avoid altogether.
3.
Review historical returns as a whole rather than isolate one or two periods.
Although a fund's 5-year compounded rate of return might appeal to some investors, what about 10-year, 3-year and 1-year returns? Although some return histories provide good clues as to the consistency of an investment's performance, unless they are all in the same ballpark, the returns may actually mean nothing more than a fund a manager "got lucky" (or really lucky) for a single period.
Ensure the majority, if not all, of the returns are consistent.
The general take-away here is simply that historical returns do have relevance, even though most people are keen on outlining how they cannot provide any indication as to future returns.
As with anything else, historical returns are not meant to be viewed in isolation; they must be reviewed in conjunction with other statistical data and measurements.
Not surprisingly, accessing this other data is not so difficult after all.
While there are several inherent problems with looking at historical rates as a predictor of future returns, these returns certainly do provide value if they are observed in the right context.
To bring historical rates into a context that is both meaningful and valuable to the individual investor, the investor should: 1.
Compare historical rates against the investment fund's overall category.
This means comparing high yield funds against high yield funds and not generic fixed-income funds; not comparing domestic dividend funds against all domestic equity funds, etc..
While there could be some overlap in a fund's mandate, its security selection and how it generates income, comparing one fund that generates returns in one area against others that generate returns elsewhere will not be valuable at all.
However, comparing apples to apples (and not apples to fruits in general) will put those returns into a context that actually means something.
2.
Review the investment fund's total performance, not just returns.
This may seem odd on the surface, but if a fund has historically performed well but performance has changed in the shorter-term, determine what else changed in that same period.
Has management turned over? Has the fund's focus changed (e.
g.
from a value focus to a growth focus)? Has their top holdings concentration shifted? What changes might explain the shift in performance? In some cases, such a shift can alter the composition of the fund and transformed it into something one might want to avoid altogether.
3.
Review historical returns as a whole rather than isolate one or two periods.
Although a fund's 5-year compounded rate of return might appeal to some investors, what about 10-year, 3-year and 1-year returns? Although some return histories provide good clues as to the consistency of an investment's performance, unless they are all in the same ballpark, the returns may actually mean nothing more than a fund a manager "got lucky" (or really lucky) for a single period.
Ensure the majority, if not all, of the returns are consistent.
The general take-away here is simply that historical returns do have relevance, even though most people are keen on outlining how they cannot provide any indication as to future returns.
As with anything else, historical returns are not meant to be viewed in isolation; they must be reviewed in conjunction with other statistical data and measurements.
Not surprisingly, accessing this other data is not so difficult after all.
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