Don't Fall for This Misleading Investment Sales Pitch

It's often just smoke and mirrors

Photo by János Szüdi on Unsplash

An easy way to make lousy investments is to put a high degree of faith in irrelevant data points.

One of the most irrelevant data points that investors use to drive their investment decisions is past returns.

If you’ve ever been pitched an investment opportunity, the primary selling feature was likely the (seemingly) impressive past returns of that investment.

In this article, you’ll learn why “past returns” are a useless data point to rely on for investing your money and how it leads even experienced investors to make very foolish decisions with their money.

Past returns make sales, low fees make money

There is no investment product where comparing past returns is as meaningless as when looking for an index fund to invest in.

If two companies offer an index fund that mirrors the performance of the S&P 500, you shouldn’t even bother comparing the past performance of each fund. Both funds do the exact same thing and should provide nearly identical returns.

Imagine you are picking between two S&P 500 index funds:

• Fund 1 has annual returns of 37.7% since inception.

• Fund 2 has annual returns of 70.1% since inception.

You might wonder how is this possible, if both funds track the S&P 500 shouldn’t they have the same annualized returns?

This is where smoke and mirrors comes into play:

Fund 1 has been active since February 2020, and Fund 2 has been active since March 2020; the only difference is that Fund 1 opened right before the Covid market crash and Fund 2 opened right as the market recovery began.

That makes Fund 2 look impressive—even though we know that impressive-looking past returns have literally zero impact on what you might expect to earn in the future or if it will be a better investment than Fund 1.

If index funds all do the same thing—and since your return as an investor is equal to returns minus fees—the best way to maximize your return investing in index funds is to pick the fund with the lowest fee.

Except many people fail to do this—instead, they focus on useless numbers like “past performance.”

A 2010 research paper ran experiments with 730 participants tasked with i picking between four S&P 500 index funds to invest $10,000. The participant’s rewards were based on the actual returns of their portfolios over a set period following the experiment​​.

They found that investors consistently failed to minimize fees. Instead, they placed more weight on annualized returns since inception.

Oh, and did I mention that the people participating in the study were mostly made up of Harard staff and MBA students from the Wharton School of Business? Who (presumably) should be better equipped to make these types of decisions than the average person.

The researchers measured participants' financial literacy levels and found that people with higher levels of financial knowledge paid lower fees—but they still did not minimize their fees.

Even when they gave people a “cheat sheet” outlining the fees of the different index funds, people still failed to minimize fees.

Even for a group of relatively informed investors with a cheat sheet right in front of them, it’s really freaking hard to avoid the allure of useless data like “past returns.”

4 takeaways to make better investment decisions

1. Minimize Fees!: Be vigilant about the fees associated with investment funds—especially when it comes to index funds. Over time, high fees can significantly reduce investment returns.

2. Look Beyond Past Returns: Investors often focus on funds with high past returns. However, past performance is not a reliable indicator of future results, especially in the case of index funds that track the same index.

3. Financial Literacy Matters: While not a silver bullet, educating yourself on how investing works has been shown across multiple studies to lead to better decisions.

4. Seek Professional Advice if Unsure: If you're uncertain about your investment choices, it's worthwhile to consult a financial advisor. This study found that less confident investors were more likely to change their portfolios based on professional advice.

Want to learn more about investing and how index funds work?

Here’s a course I created that gives you the 101 on passive index investing:

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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.