In the investment industry, one of the most common disclaimers you will find is “past performance is no indication of future performance.” Despite these words of caution, investors continue to practice the one strategy that does not work consistently – chasing performance.
Choosing investments based on past performance is much like driving a car looking through the rearview mirror. It may work for a short while but eventually it will lead to big problems.
Chasing performance is very dangerous, yet it happens over and over again. The unfortunate reality is performance sells: Emerging markets in the early 90’s, the financial boom in the mid 90’s, technology in the late 90’s and now the Oil and Gas boom. Last year’s past performers always attract the most new money and investors follow like lemmings.
My advice is simple… don’t chase last years winners! Think about it, if it were that easy, we should be able to buy last years winners knowing it will be this years winners know it will be the following years winner and so on and so on. Unfortunately it is never that easy and far too often we get burnt chasing those winners. Here’s some advice on how to use performance in a meaningful way in order to make better investment decisions:
- Use objective benchmarks. If I told you that investment X made a 7% compound return over the last 5 years, some of you would think that investment is excellent. Others would be unhappy with a 7% return. Performance is subjective depending on what you perceive to be a “decent” return. As a result, it is always better to try to establish realistic, objective performance benchmarks.
- Think portfolio instead of individual. Quite often investors will look at their portfolio of investments and zone in on the weaknesses. For example, you may have a portfolio of 5 investments with returns of 31%, 15%, 10%, 6% and –8% and immediately you second-guess the fifth investment. Likely, the thought that crosses your mind is to keep your winners and sell your losers. Keep in mind that a properly diversified portfolio will often have components that under perform from time to time. This portfolio averaged over 10%; a solid return by any standard.
- Buy low, sell high. Logically, this strategy should work best when it comes to investing. Unfortunately, it is difficult to practice because our emotions lead us into believing buy higher sell lower, or chasing performance is the best strategy. The reality is buying low is a difficult thing to do. It takes courage, discipline and independent thinking. Buying low means buying the losers like the –8% investment above.
- Remember time and patience. One of the mantras of investing is long term patience. Despite any random short-term ups and downs, over time, good quality investments should appreciate given time. It’s difficult because we live in a society where faster is better – “just add water”, “lose weight in 30 days”, , no money down and “work smarter not harder”. Society has taught us that the path of least resistance is the best path and there is little time for patience. Just remember investment success requires some patience!
According to my research on mutual funds, chasing performance works about 15% of the time. In other words, if you buy last years winner, you have a 15% chance it will be a winner in the following year. To me, that means 85% of the time, it will not work and that is just not good odds for a successful strategy. The bottom line is everything goes in cycles. What goes up comes down and what does down come up. Think about that the next time your heart tries to tell you to buy last years winners and sell last years losers.