Beware the Market Hypothetical
Professionals and individuals alike make major financial decisions based solely on past investment returns. This is a huge mistake. Given that the average 5-year return of the S&P 500 now stands at 15%, these hypothetical returns show unrealistic promises of high returns.
Most financial advisors use market hypotheticals in their presentations to make the case that their investment model is superior. They hope that the unsuspecting investor will ignore the warning “past performance is not an indicator of future outcomes” in fine print and will chose the investment or financial advisor that shows the greatest return potential.
Throughout my career, I’ve seen the worst investment mistakes made when people chase past performance. Here are five helpful tips on how to avoid this mistake:
Gimmick – There is a very large presentation book filled with charts and graphs that show hypothetical performance and no actual performance.
Tip – Make your decision based more on the investment philosophy and experience of the advisor or firm who will be managing the money. Is the investment process repeatable? What are the qualifications of the advisor?
Gimmick– A mutual fund fact sheet is shown with very high returns.
Tip – Ask the advisor for the worst 1, 3, and 5 year returns for that same investment.
Gimmick – A model portfolio based on risk and no actual returns is presented.
Tip – Request to see actual returns of clients. If real returns are not available, ask to see a client reference list.
Gimmick – A proprietary mutual fund is selected by the financial advisor. This is an investment managed by the company that you are meeting with.
Tip – In 99.9% of the cases, this mutual fund has much higher expenses and has likely underperformed its benchmark. Ask to see if there is an exchange-traded fund equivalent with lower fees and higher returns.
Gimmick – An annuity is recommended by showing you hypothetical returns with income expectations for life.
Tip – Request to see what the total expense will be for that annuity over a 5 and 10 year period. Determine when the original investment principal is exhausted.
At this point in the market cycle, investors need to be very cautious on selecting their investments based on past returns. I have seen more and more hypothetical investments from other financial advisors that will not be repeated. It is very easy to construct models that are backward-looking and misleading. My recommendation is to tear them up and recycle the paper.
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