My financial adviser is telling me to invest into a range of funds based on their investment performance last year. Is there any relationship between last year's investment performance and the future performance?

A turkey sits all year with the belief everyone cares about it. As each day goes past, it believes it can't get better. Each day there is more food as the turkey hears the concerned farmer talk about the turkey losing weight. Eventually, the 364 days of looking back at what has happened assists the turkey in getting it in the neck. And day one of the cycle starts again.

Investment performance is no different. The future needn’t be cranberry sauce. I have been trained to believe that all data is noisy and my job is to see through it. This is essential when deciding where your ISAs, pensions and investments should be invested.

The difference between the best and worst investment performance is considerable. Take the UK all companies sector. This is a popular choice of destination for much of investors' funds whether it's an ISA or pension fund. The worst investment performance fund for last year returned 0%, the best, 47.2% and the average fund returned 11.2%. Of the 308 funds in the sector only 124 performed above average (1).

Amazingly, over five years, only 130 funds performed above average as well.

So we know there is a vast difference in investment performance, but how do we know if it isn’t a fattened turkey?

The key is in assessing investment performance correctly and seeking independent investment advice. Just because a football team has won its last game doesn’t make it the best team. So what information about previous investment performance is useful in determining the future performance, and what is not?

Firstly you might need to understand how marketing works. A fund that has taken a larger position in, say, China, over the last 18 months may look favourable in its results, so the inevitable marketing will ensue. Investors will look at the last year's results and see a large gap between the performance of their cash and that of the high flyer, and so they queue hop just in time for the man in front of you to take out his bag of one pennies and begin counting i.e. China nosedives and you buy when it is at its most expensive. The following year, still miffed with the man in the queue, you hop again just in time for everyone in the other queue to do the same. Queue hopping, or fund hopping, is one of the easiest ways to lose money and it's on the basis of asking for the wrong information off the historical investment performance data – how well has it really done?

So what's the easiest way to do it? We all want to know who is consistently likely to be in the top sector of all funds. The way to look at that is to see which managers make the most consistent decisions. So rather than seeing that a long shot bet in China worked just before the chef brandished the cranberry sauce, it would be better to see which manager consistently made alterations to their fund given the different market conditions and made the right choices and consistently made you money.

To do that I buy in detailed research about the fund manager and how they make decisions. On top of that I assess the performance of each manager in individual months of the year over 60 months. In each month I give them a consistency ranking, and then I assess how much risk they are taking to get the return. There are many funds which fluctuate wildly to achieve 10% return but I want the correct fluctuation for the return I am receiving.

Far too many investors choose solely on the past investment performance without assessing what risk has been taken to achieve that. That can be very expensive indeed.

By assessing consistency of return and risk we can comfortably bring consistent fair returns which are in the top sector.


(1) Trustnet

Average for the year

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The value of shares and investments can go down as well as up

Peter McGahan is an Independent Financial Adviser and the Managing Director of Worldwide Financial Planning Ltd who are authorised and regulated by the Financial Services Authority. 'The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.'

Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made.
The above represents the personal opinions of Peter McGahan.
All information is based on our understanding of current tax practices, which are subject to change.

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