I am going to ask you to choose between two hypothetical funds with a similar investment strategy, to hold long-term in your SIPP or ISA. In the last year, Capital Guard returned 8% and Wealth Defender grew by 5%. Which one do you choose?
Lesson 1: Don’t be short-sighted
Making a decision to buy (or sell) a fund based on short-term performance could leave you chasing returns by moving out of one fund and into last year’s best performer. Trading costs will eat into your savings. Furthermore, according to a 2004 study done by Vanguard Investments Australia, most of the top-performing funds in one year do not make it onto next year’s list, making further trading more likely.
If you are saving for the long term, then chose the fund with the best long-term performance. What is the long term? Well, at least seven years and almost certainly 30 years, but 10-year annualised performance is a good place to start. You want to see how the fund performs in both good and bad times, and how it deals with a changing economy.
Lesson 2: Results may vary
Let’s return to the Capital Guard and Wealth Defender funds. We have 10 years of performance data for them now, with the former returning 5% and the latter 3.5% on average over that period, and so Capital Guard seems to be the one to go with.
Looking back over the performance history you see that there were a couple of years where Capital Guard made negative returns of not more than 1%, and although Wealth Defender made 0% a few times, it never reported a negative return. Have you changed your mind about which one to buy?
Higher returns usually come with higher risk, so it should not be surprising that Capital Guard has more volatile returns compared with Wealth Defender and periods of poor performance can and do occur. The drawdowns are very small so it appears that excessive risk is not being taken. A well-managed fund with a consistent investing plan that has performed well over the long term will probably do so again. So, why not reach for the higher return if you have time on your side to recover of any losses that may occur.
There are no guarantees, of course – both of these funds could perform very differently in the future compared to the past, which leads us to the final lesson.
Lesson 3: Stick to the plan
Our hypothetical funds both claim to invest in large-cap UK income stocks, which is what we wanted. A fund that is moving away from what it was good at, as Neil Woodford’s Equity Income Fund did, is a warning that the future may not at all be like the past.
If our funds start reporting increasing exposures to European or US equities or growth and small-cap stocks start appearing in their holdings, then they are no longer what we are looking for. Also, check to see that the management team responsible for the past performance is still in place.
While it is absolutely true that past performance does not guarantee future performance, having a consistent investing style and management team should give us more confidence when using historical data to inform our choices.
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James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.