Making Investment Decisions

Like all industries, the financial services industry uses advertising and sales brochures to convince consumers they should invest in a particular investment product.  The material usually provides important information to help the consumer/investor make a logical decision.

The automobile industry tells you about mileage and horsepower.  With food and drink, it’s about calories and fat.  With investments it’s about past performance.

But when reading ads for investment products, consumers should realize there is a big difference.  Six months after you purchase a car with 200 hp, it will still be delivering 200 hp.  After you purchase a can of Coke Zero it will still have zero calories when you consume it.  With investment products however, it is more difficult to know what you are getting.  That is why every ad is required to state: “past performance cannot guarantee future results.”  That is probably the most important piece of information in the entire ad, but it is often ignored.

Investors typically look at the past, and make their investment decision based on everything that has happened up until the moment they make the investment.  But investment returns will be based upon everything that happens from that day forward.

The financial services industry would like you to believe that past returns are an indication of what returns you can expect in the future.  But that is simply not true.  Every event going forward, from the day you make an investment, is going to impact your investment returns.  The stock market moves up and down, interest rates and bond prices do as well.  And in my opinion, no one can predict accurately, with consistency, which way they will move.

To illustrate lets look at a simple example, Long Term Government Bonds.  The YTD return has been 17% due to declining interest rates this year.  However, an investor expecting a similar result in the future may be in for a rude awakening.  A 30-year bond, with a coupon of 3%, will lose almost half of its value if long-term interest rates should move up to 6%.  And, the higher interest rates rise, the greater the negative impact on the value of long bonds.

Back in the late 70’s and early 80’s, when interest rates and inflation went to double digits, it was painful to watch retired people come into the brokerage office wanting to exchange 3% AAA long bonds for the higher yielding 10% bonds being sold at the time.  What a shock to discover that their bonds had lost more than half their value.

I am not saying long bonds are a bad investment.  I just want investors to be aware of the risk of owning long bonds.  Something they may not have considered.  Using the past to make investment decisions can be very detrimental to one’s financial health.  Remember, past performance is “never” a guarantee of future returns.

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