Why performance is not a good indicator when selecting a financial advisor

David E. Hultstrom, President of Financial Architects, recently explained why past-performance is not a great way to evaluate financial advisors. Essentially, no one has a working crystal ball. Hultstrom wrote the following in the May, 2023 edition of Financial Foundations.

Why would I leave out past performance in selecting an advisor, or current performance for an existing advisor? There are a few reasons:

1. You will never have a long enough track record. I have explained this at length elsewhere but to know a portfolio manager who has been beating the market by 2% annually (which is enormous) actually has skill would require a track record 56 years long. (This is a difference of means test assuming 2% alpha, 20% standard deviation, and 90% correlation with the benchmark.) Thus, realistically, you will never know with any high degree of confidence whether a portfolio manager is skillful. I wish it were otherwise, but it simply isn’t.
2. Good performance may just mean extra risk. An advisor who placed a client in an inappropriately risky portfolio will nonetheless look like a genius when the market is going up. There is an old Wall Street saying, “don’t confuse brains with a bull market.”
3. Underperformance may just mean prudence. Good investment advisors were appropriately diversified in the late 1990’s and thus trailed the market (remember “irrational exuberance”?) by a wide margin. While those advisors were vindicated in the early 2000’s many had already lost a significant number of clients – who frequently returned to them with much diminished portfolios.

So, while it is somewhat counter-intuitive, there are many factors that are useful in evaluating your financial advisor, but performance isn’t one of them.

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