You know that past returns are not indicators of future performance, right? You've read that on a billion mutual prospectuses. Nonetheless people tend to use their past returns as their primary motivation for selecting new ventures and speculations.

This is probably a combination of everyday human nature, the historical charts and graphs they feed us, and the shortcomings of available information for retail investors, like you and me. You see, mutual funds give very little information for people to evaluate them by, so we take what we can get and we roll with it. This is far from the ideal investment strategy.

Past returns are insufficient primarily because they only paint a very small picture of the overall investment management picture. Past returns are incapable of telling you how those specific returns were made, whether or not they were consistent with the strategy of the investment manager, or even why the investment manager decided to choose the assets that he or she chose.

Given the option to choose, would you choose an investor who made 10% by following his own preferences and investment strategy, or an investor who made 12% but did so without following any clear preference or strategy? The correct answer is to choose the first investor, who followed a strategy. The first investor in the example set out to achieve returns by following a clear path, where the second investor did not. If the second investor made a 12% return, it was purely by luck.

So how do the pros in investing choose their investors?

The best way to answer this question is to turn to the managers of premier endowment funds at prestigious universities such as Stanford, Harvard and University of Pennsylvania. Between them, these prestigious managers oversee more than hundreds of billions of dollars in funds, meaning that they have an obligation to make the right choices.

When choosing stock investment managers, these premier endowments are looking for three specific things:

1. Excellent risk-adjusted returns.
2. Compelling rationale for investing.
3. Adherence to a stated style and preference for investing.

While no one can be completely immune from loses, investment managers that score high on all three of these dimensions are skilled rather than lucky, and therefore are much more likely to exhibit returns that are consistent.

Why should you be settling for less?

kaChing is releasing a brand new proprietary metric that is inspired by premier endowments and that they believe to be a better solution to evaluating rock star investors. They call it the Investing IQ.

There are 3 components making up the Investing IQ:

1. Risk adjusted returns based on the information ratio.
2. Quality of rationale for your positions.
3. Sticking to strategies.

They then combine your individual score for each of these components, assigning a score out of 100, where higher is better just like with school grades. Is it going to the change the face of investing?

Photo Credits: vramak

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