The Peter Principle refers to the concept that an employee within an organisation will continue to be promoted until they reach their “level of respective incompetence”, the very limit of their capabilities. At which point they are “found out”.
It seems to be a fairly common, and cruel, situation. An individual, perfectly competent in one setting, can effectively end up a victim of their own success.
Their career progresses right up to to the point where it doesn’t.
In many cases, past performance - something or someone’s track record, offers the best indication that we have as to what the future might look like.
But by definition, the future is unknown and unknowable. None of us have a crystal ball, and we are all just making our best guess as to what happens next.
One thing that the modern investor is not short of when it comes to making a decision, is information.
It is of course important that investors are well informed, but take even a cursory glance at a fund factsheet and you will be confronted with an informational overload - a breakdown of holdings within the fund, pie charts showing the geographical spread of investments, the dividend yield, an estimate of the “risk” of the fund (which may or may not be based in reality), the costs and charges. And past performance.
It is natural for us all to look at the performance track record of an investment and extrapolate that forwards.
But in many ways, past performance is the least helpful metric that we have available to us when determining the merits of a given investment strategy.
Investing based solely on past performance is like driving while only looking out the rear window. It can work for a while, but you are playing a very dangerous game.
Dangerous because mean reversion is real. The data show that there is little to no evidence that investment outperformance persists over time.
Over the four years to the end of 2023, only 8% of Global Equity managers based in Europe managed to remain consistently in the top half of the performance league table of similar funds. The numbers get worse for US Equity managers and UK Equity managers based in Europe (both around 3%).
And it’s not just European fund managers either - this is a consistent story around the world.
What does this mean? Well, it means that if you are selecting a fund manager based solely on the fact that they have demonstrated good recent performance, then the data tell us that you should prepare yourself for disappointment. That manager who is “top of the pops” at the moment is likely to start slipping down towards the relegation zone fairly sharpish.
This matters because when returns starts to disappoint, performance chasing investors will naturally move onto the “new thing”, the new strong performer.
Pretty quickly they find themselves trapped in a cycle of buying funds after a period of outperformance and selling them after a period of underperformance. Which isn’t a great strategy for making money.
“Past Performance Does Not Guarantee Future Results” is the classic line that every fund manager and financial adviser plasters all over their marketing material to keep themselves out of prison. But do people actually take heed?
In 2021 researchers from Leeds University found that, despite being given the classic “past performance…” warning in advance, 1,600 US investors persistently chose investments that had demonstrated good past performance, even when they knew that that strategy had higher fees and costs.
We can warn people all we want, but there is something so seductive about the promise of outperformance that people don’t seem to want to listen.
If you can just find the right investment strategy, the star fund manager, you don’t need to bother with the difficult stuff - the patience, the saving, delaying gratification.
The promise of outperformance is a kind of financial diet pill - a short cut to success. The ultimate marketing strategy. The only problem being that the data suggest that this promise is simply a mirage.
If we accept that consistent outperformance is so elusive, then investing based on past performance has another fairly major disadvantage - it is high maintenance.
Constantly chasing the "new thing" is not only a suboptimal investing strategy, but also utterly exhausting. There are many, many better ways to spend your time. Going to the dentist, for example.
By all means consider the track record of a given investment strategy before you choose to follow it. Solid past performance is a hygiene factor, it is table stakes.
There is very little point in taking an investing approach which has never worked, and good past performance can be evidence of a sound investment process.
But I would suggest that there are bigger, more fundamentally helpful questions to ask, namely:
Do I understand this strategy?
Does it seem logical to me?
Do I understand the risks and trade offs involved?
Is the approach grounded in a truly objective, historically sound methodology?
How widely diversified is the fund?
Does the strategy follow a pre-determined set of investing “rules”, or is it reliant on the whims of a human being/team of human beings to implement decisions?
If the latter, do I trust these people? What happens if the fund manager resigns/retires/gets hit by a bus?
How easily can I buy and sell this investment?
What is the tax treatment of this investment?
How long has this product been in existence?
What will the costs and charges be to me?
I will admit that doing this level of diligence is probably likely to take more time up front than just ordering a bunch of investment funds based on how they have performed in the past.
But this is one of those decisions where it is worth putting in the initial groundwork because the best investment approaches have a “set and forget” quality to them. One decision strategies - buy.
A “high touch” investing approach by contrast will leave you exposed to the investing equivalent of the “Peter principle”. By the time that you run up against the limits of your capabilities, it will likely be too late.
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