According to a new study by State Street called “The Folklore of Finance: How Beliefs and Behaviors Sabotage Success in the Investment Management Industry” (which can be accessed here), investment professionals use easy to articulate – but often incorrect – guidance for making and justifying investment decisions.

We’d like to comment on a few of these folklores, and first up is the folklore of time.

The folklore of time describes beliefs related to what occurred in the past and what may occur in the future.  For example, the paper says that investment professionals rely heavily on analysts’ expert forecasts (which are essentially a prediction of the future).  Evidence shows, however, that when measured properly, accuracy rates of these forecasts over 24 month time frames are as low as 5% – 10%.

How much confidence would you put in forecasts with 10% accuracy over two year periods? Probably less than the investment management industry apparently does.

The folklore of time doesn’t merely affect attitudes about the future.  The State Street study finds that investment professionals also show a baffling tendency to rely on past performance when making investment decisions.  This is despite the truism that past performance is no indication of future results.

The State Street study corroborates this truism with a study of 715 US stick market funds which posted top quartile performance in March 2010.  After four years, only two (yes, that was two!) of 715 had maintained that top performance throughout the subsequent four year period.  Persistence in performance is a myth.  Authors also point to another study that shows that managers fired because of poor past performance often subsequently outperform the managers hired to replace them.

The fact is that relying on extrapolations of the past or predictions for the future, even those provided by experts, is a very dangerous way to invest.  Yet given the uncertainty we all face with investing, our brains are hardwired to do just that.  The alternative, of course, is not to focus on predicting or extrapolating financial markets.  Instead, focus on holding a low cost, widely diversified and carefully monitored portfolio, which can achieve your long term goals and is less likely to experience inevitable downturns that you can’t stomach.

And, having done that, do something completely novel (at least in the investment industry).  Enjoy the present!