In personal finance, past performance is not an indicator of future: How to make an informed investment decision

I shouldn’t have quit my job, she lamented for the tenth time. We had only been talking for a little over an hour. She described in detail how successful she was and how accomplished and appreciated she was at work. And then she gave it up because she got sick. I didn’t ask the only question running through my head: but what has stopped you in the 15 years since you got better? I was nice.

But his voice stayed in my head. How many of us live in the past! We can’t easily dismiss it. Many of us like to rearrange our lives on a regular basis, rearranging certain blocks from the past. If only I had studied this rather than that; or took this work on that; or lived in this city than that. etc We make choices. All the time. It’s unfair to ourselves to go back and question this, because we can only choose one of the many choices we had at the time. It’s like that.

There is a mirage at play. The successful lives of accomplished people are portrayed gloriously in public. Many find it inspiring to know these stories. Only partly, I think. Where we are today is known. And then we come back to fit a model to all those correct choices that person may have made. As if that was the only choice they had. How biased!

At each turn, we will be faced with choices. Many of them will fail to deliver. Some will be right. And catapult one to glory. We selectively look at things that went well. We give the impression that these were specific deliberate choices. As if these steps to success were so well known and presented so well. No. Enough trial and error. Except those stories that didn’t end well don’t get as much attention and analysis.

The problem with these generalizations of success is not just this selective bias. But a dangerous oversimplification of decision-making itself. Most like to believe that a path to success can be specified. We discount the reality that at every turn a choice was made, and that choice had a high probability of failing. We don’t like the word luck, and we attribute success to deliberate choices, made not by chance but with foresight.

Investing is difficult for this reason. We choose a stock, bond, fund, property or whatever we like to invest in. If it turns out to be good, we are satisfied with ourselves. We may have cracked the code, we think. It turns out to be bad, we look at all those choices we didn’t make and feel guilty. IPOs are routinely overvalued when offered and underperform after listing because we suffer from this bias.

You miss a winning IPO and tell yourself that the only way to make up for that loss is to buy the next one. The next one will have a high price given this line of avid investors. Poorer and poorer issues will begin to hit the market as investors adapt a model for each IPO that arrives. So much so that many will swear you can’t lose money in an IPO – it has to be on top.

The data does not support this belief, popular as it is. The good ones are only rare; the bad and the ugly are too numerous; and investors can’t tell. The other extreme reaction to this fiasco is another group of investors who will steer clear of IPOs altogether. They will have nothing to do with this game, because they believe there is no money to be won. Caught in the middle are the experts who must evaluate and rank IPOs and make recommendations. They fumble and get right and wrong, and since people forget, all is well.

We just can’t handle regret. We deny; we justify; we blame. Sheena Iyengar wrote years ago that having too many choices makes decision-making difficult for the human brain. The irony is that people don’t like that there aren’t many choices; the greater the number of choices, the less likely people are to make decisions easily.

Is there a model for investing in stocks, people ask. There has to be something to help choose the right stocks to invest in. When most of the world believed that stock markets were wild speculation or an expensive gamble, Benjamin Graham led the way in 1934. He came up with what we now call fundamental analysis. Stock prices are determined by underlying merit, he said, lending nobility to a much maligned profession.

In the years that followed, people played with all the tricks other than hard work and intensive analysis that Graham offered. There is still no infallible model; but there is a solid approach to picking stocks. The hard work of understanding the business, analyzing the numbers, evaluating managers and making judgments. This is nowhere a prediction. A judgment is only as strong as the information on which it is based.

The best stock pickers understand that they may have missed something; that something might change that they haven’t adequately assessed. They therefore remain humble; they remain ready to be contradicted; they know that new information can change each of their assumptions. That’s why they don’t look to the past to connect the dots and create a pattern; they work dynamically and look to the future.

This approach is tough. It takes courage to make a decision and dynamically evaluate it and make course corrections on the fly. What can simple people do?

We can work within our context and our means to stay focused on the present. We can imagine a future we desire and do our best with those assumptions. We can remain dynamic and humble. My friend who quit her job may realize that her regret means nothing; she can go back to doing something else that will allow her to accomplish more.

Sometimes we don’t see that the past doesn’t matter as much as we think. In personal finance, past performance is not indicative of the future. And that’s a good thing, right?

(The author is president of the Center for Investment Education and Learning.)