You’ve probably seen the phrase in investment articles, as a footnote to performance histories, or maybe even heard it in a meeting with a financial advisor.
Why is this phrase so important? What does it mean? If past performance can’t guarantee future returns, what can?
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Protecting the Government by Protecting People
The government requires professionals to state this phrase when speaking about investments to help protect average investors. Before regulations like this, it was easy for devious salespeople to sign people up for extremely risky investments by simply saying “This fund has gotten an incredible 50% annual return!”
The problem arises when we look at how risky the investments would need to be in order to have gotten those 50% returns.
People would sign up, expecting to get that amazing return, only to suffer massive losses the next year. And they would have had no warning that something like that could happen.
This put savings and retirement at risk. So, in order to protect people, and thus protect themselves from needing to pay out more benefits, the government issued this regulation. The hope is that by hearing it, people might invest more cautiously, and thus lose less money in the long run.
Tempering Our Emotions
One of the best ways to lose money when investing is to invest emotionally. When we invest with our emotions, rather than with our rational mind, we more easily make poor trades and lose money.
Seeing a large number in a mutual fund’s performance history can make us feel strong emotions – excited, desire, or even fearful of missing out. If these emotions push us to make a decision before we’ve taken in all the necessary information, we might miss some obvious red flags about the investment.
The phrase should give us a chance to take a moment and think through our options. By detaching our emotions, we can make a decision based entirely on the factors that will really lead to higher returns in the future.
So, if we can’t make a decision based on how the investment has performed in the past, how do we make a choice?
Rather than looking at previous returns, we can examine how the investment actually functions.
If we’re looking at a mutual fund, how diversified is the fund? Does it have a low expense ratio? How does it implement its trading strategy? Does it have a history of high volatility? How would that volatility fit with your investment strategy?
This is where a financial advisor can add a lot of value. A good one can help you answer these questions so you make the best decisions for your circumstances.
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