Chasing winners is a frequent investing habit which, more often than not, results in disappointment. As Morningstar puts it, "investors often suffer from poor timing and poor planning … many chase past performance and end up buying funds too late or selling too soon.”
So why are yesterday’s winners so frequently tomorrow’s disappointments?
Historical performance is useful for identifying who outperformed in the past. Unfortunately, past performance often tells us very little about the future. One major reason is that the success of many strategies is market specific – it is unlikely that Fund “A” outperforms Fund “B” in all market environments, so choosing the winner between Fund A and Fund B will have as much to do with predicting the market as it does with kicking the tires on the funds themselves.
Markets Do Not Forecast, Nor Do They Repeat
I’m an investment professional, and I am unable to predict how the market will end next year or what path it will take. I am going to go out on a limb and posit that my peers in the industry don’t know either – though many will provide their forecast and some will be retroactively “right.” I also do not know which strategy will perform best and which manager will “manage” to that strategy best, and nor do my peers.
The last few years in the market have been rather unique. We have seen interest rates go negative globally. We have seen a period of unusually low volatility with strong market performance perhaps due to an unusual amount of support from the Fed. Perhaps we are going into a new market environment now (but then again, perhaps not – who knows?).
Will strategies that have performed well over recent historical markets (e.g., over the last 3 years) remain performance leaders going forward?
Doing this “last few years” exercise demonstrates just how difficult it is to predict winners. If we measure winners between the time periods of 2007 – 2009, 2010 - 2012, and 2013 to 2015, we will come away with different sets of winners. What does that tell us about who to invest in for 2016 to 2018? Not very much.
For example, Tactical strategies as a group performed very well in some recent years and then did the opposite. The same goes for managed futures. Does this make them good, bad or middling strategies? No, not necessarily. It depends on the market environment.
Focusing on equity markets, the following distribution curve illustrates the historical one-year performance returns of the S&P 500 going back to 1950. As you can see, the range is all over the place. Analysts as a rule are not known for accurately predicting performance one year forward. Further complicating this is the career path nuances of the analyst profession - well-known analysts are better served placing a “down the fairway” number on their prediction, since they don’t want too much egg on their face, while lesser known analysts are better off taking a shot on predicting an outlier (if they are right they may get some positive attention but if they are wrong, it will likely escape notice). Next-year returns can really fall anywhere on the spectrum, with a 20/20 hindsight narrative that make the outcome look obvious in retrospect.
Not only are strategies at the mercy of overall market performance, but also the nuance of the path the market takes to get there. Even if I know the market is going to return 5% next year, the degrees of volatility and correlation among stocks will affect whether a long/short strategy is likely to outperform.
There are infinite paths the market can take going from a known point A to a known point B. Here are four historical one year time periods showing identical market performance with wildly different paths:
Except for the most static strategies, the path will not only have a different effect on the performance of a strategy but will affect the investor and how they interact with the market. At points of stress, does the investor decide to adjust his strategy? Here’s an illustration: In the 2004 performance line above, the market went from +6% to -2% in about six months – it must have been pretty tempting for someone with market exposure to rotate to defensive strategies at that point, but that would likely have been the wrong move as the market then proceeded to zoom up 12% over the next four months.
Learning to Set It and Forget It
Given the wide range of potential market and fund outcomes, the likelihood of repeat strong performances is low. Rather than picking winners, investors should pick funds that deliver a return profile that fits their needs and temperament.
Can an investor live with investment strategies that do not have a lot of definition surrounding risk and return? Behavioral finance gurus such as Khaneman and Tversky suggest generally not. People are generally governed by their aversions, and open-ended risk and ambiguity almost inevitably leads investors to fret about their investments. When constructing a portfolio, it is important to keep aversions in mind when navigating the client through the thick and thin of what the market is likely to give them. Given that we are certain that there will be uncertainty, here are some suggestions:
- Use a strategy (e.g., defined outcome investing) with clearly defined worst-case scenarios and risk-return expectations.
- Communicate those expectations to clients so they can comfortably manage their personal fears. The more clear those expectations can be illustrated to clients and seemingly followed in the future, the easier it will be to manage client expectations.
- Stay away from investment situations not easily understood or ably explained.
Adhering to these guidelines can result in an investment strategy that brings clarity to a market that tends to be unclear, and help clients avoid chasing yesterday’s winners, which rarely turn out to be tomorrow’s top performers.