Can we really consistently pick investment winners?
Have you ever dreamed about what it would be like to have the ability to foresee the future? Just think about the possibilities. Imagine if, on December 31st of every year, you knew what the best investment for the following year would be. Having this foresight would be kind of like winning the lottery. You would be a millionaire in no time at all!
Let’s say you invested ten thousand dollars (one time) and succeeded in picking the best performing investment category every year since 1987 out of 20 different asset categories. Today, you would have turned that $10,000 into $7,000,000 dollars in 20 years. That translates to a whopping 39% compound average annual return.
Compare that to investing the $10,000 into a diversified portfolio of those 20 asset classes and your investment would have made an 8% compound average return over the same 20 years to give you an accumulated balance of $45,000. Now that’s a big difference in results between $7,000,000 and $45,000. All you have to do to get the better result is to be able to predict the future consistently for 20 years.
There is no such thing as perfection in investing
If perfection existed in investing, we would not need thousands of investments to choose from. One of my favorite investment quotes comes from George Hartman, author of RISK is a Four Letter Word. He said it best when he stated that “investing is an inexact science: it is better to be approximately right than precisely wrong.” As a result, I believe that rather than focusing on trying to find perfection, look to increase your probability of being right more often than being wrong and you will be leaps and bounds ahead of the pack. One of the best ways to increase your probability of success is to avoid chasing performance.
Don’t chase last year’s winners.
Chasing performance is by far the biggest mistake investors make. If you take a look at your portfolio, chances are your first instinct is to keep your winners and sell your losers. It’s natural to think that those investments that did the best will continue to be the best and conversely, those investments that did the worst will continue to do the worst. We call this ‘linear extrapolation’ or thinking in straight lines.
We know this happens because the buying patterns of investors are clear. There is over an 80% correlation that last year’s best performing investments will be the following year’s most popular investments. And yet, for most of us, we can rationalize how the ‘buy low, sell high’ strategy makes sense but chasing performance is the polar opposite (buy high, sell low).
According to my research, last year’s winners have about a 15% chance of repeating is a winner for two consecutive years. In other words, chasing performance does not work 85% of the time. Markets are unpredictable. You can get lucky from time to time but success cannot be sustained for a long period of time. Even the greats of investing like Warren Buffet, Peter Lynch, or Sir John Templeton get it wrong from time to time. Long term success does not lie in being right all of the time but rather being right more often than wrong.
The bottom line
Chasing performance just does not work. If it were that easy, we would all buy last year’s winners knowing they would be this year’s winners knowing they will be next year’s winners and so on and so on and so on.
Practically, remember that everything goes in cycles (interest rates, stock markets, sectors, mutual funds, economies, businesses, etc). What goes up can come down. What goes down can come up. What goes up the most comes down the most. What goes down the most goes up the most. Just because it was the best, does not mean it will stay the best.