Should you invest based on past performance?

Learn from the past, but don't live in it.

No, we are not drawing a parallel between life and investing. We mean it literally. While a stock's past performance should be considered, it should never be the sole reason for you to invest.

Often hype and, at times, the market's infamous shortsightedness drive share prices of duds up for a while. And when the fog clears, and the market finally has an epiphany, prices plummet.

So, a strong past performance should never be seen as an omen for grand returns ahead.

The numbers agree with us
To prove our point further, we conducted this simple exercise. For each year from 2014 to 2018, we invested in the top ten stocks with the highest annualised returns in the past five years. For example, for the year 2015, we invested in stocks that gave the highest annualised returns between 2009 to 2014.

Next, we calculated how much annualised returns our investments would fetch if we held them for five years.

Here's what we found.

• For each investment year, nearly half of the companies gave negative returns. As a result, the overall returns were abysmal.
• The list of stocks we invested in changed drastically, even though we conducted the exercise for consecutive years. This was because the top performers kept changing, a sign of inconsistent performance.

Conclusion
The above exercise shows how risky investing solely based on past performance can be. However, investors should note that we are not implying or downplaying the importance of past performance. A past of high returns should indeed invite further exploration.

But, investigating why the stock performed well, and if the factors that led to the rally are sustainable, is far more crucial. Over the long run, companies with consistent growth will build you wealth, not those that shine bright momentarily and quickly fade away.

This article was originally published on June 21, 2023.