Past performance does not guarantee future results.

February 02, 2023

That disclaimer is attached to the bottom of many of these articles that you read. As a matter of fact, it’s likely the single most used disclaimer in my industry. Why would you care about this disclaimer and what does it really mean?

A while ago, we talked about a psychological idea called negative stimulus avoidance. We discussed how the human brain is geared to help us avoid being hurt or damaged. Negative stimulus has an outsized effect on our decision-making process if we let it.

Let’s talk about another important psychological issue that may cloud your judgement as an investor: recency bias. In my opinion, recency bias is even more dangerous than our desire to avoid negative stimulus. Recency bias is extremely simple. We as humans tend to assume that things will keep going just as they have been going in the recent past, for better or worse.

That’s where a flaw in our brains tends to short-circuit. Humans tend to see recent performance, and blindly expect future results to be much the same. Many times we actually search for data that supports our flawed point of view. A stock has gone up? Let’s use that as the base reason for it to continue going up! If an investor owns products or securities that have generated tremendous returns, they are much more likely to keep that investment than they are to keep one that has lost value, regardless of what empirical evidence may show.

In reality, the past performance of an investment should only be one small factor in our decision to keep or buy it. A prudent person attempts to understand WHY that investment has generated such positive momentum. Why has that company’s stock gone up? Is it because of its growth? Has it increased profitability? Has it gone up just because the entire market has risen, taking it along for the ride? Has

someone on reddit decided to launch a massive peer-group purchase of the stock, pushing its value to unrealistic levels?

Once that information is obtained, a smart investor will attempt to judge the likelihood that this reason is likely to keep pushing the stock price higher. The more a shrewd investor knows, the more accurately they can gage an investment’s past performance and its odds of continuing that performance into the future.

Recent performance matters, don’t let me make you think it doesn’t. Recent performance, however, is not the only reason to buy, sell, or keep an investment. Try to investigate the “why”. A stock has gone up? Why??? Land values have increased? Why??? Used car prices have jumped? Why??? This logic applies to every asset. If you can understand the reasons behind recent performance and keep an open mind about what that information tells you, then you’re very likely to make more intelligent decisions about what to do with an investment. Do your best to eliminate recency bias and let the research tell you what you need to know.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.