New Year’s Investment Resolutions – #2

Tuesday, December 29, 2009

Number 2Continuing with my favorite resolutions this week – ones that work in all markets – here is number two.

Performance results are the most popular investment measure. Certainly they are needed to know how we have done. The problem comes when investors select investments by how well they have performed.

Every investment report or advertisement using performance numbers must include the phrase: “Past performance is not indicative of future results” or similar wording. This is not one of those legal phrases like “The opinion expressed here…” or “I have read and understand this website’s conditions….” Rather, it expresses an absolute truth:

In investing, you cannot count on the past to tell the future.

Yet, many (most?) people buy good performance and sell poor. Why? There are a few reasons:

  • Because performance is what we are striving for, it only seems natural to invest in something that has done well and avoid the rest.
  • The media is filled with articles and reports that imply past performance is the key selection tool. From Morningstar’s and others’ rating schemes (all based on performance) to Top Ten lists of best and worst performers, past performance is the be-all and end-all.
  • Outstanding performance breeds popularity. When we keep hearing about how well an investment “is doing” (that is always the implication – it should be “has done”), and everyone seems to be riding it to riches, the siren song is enticing.

The problem is that a Money Magazine investment performance analysis is not like a Consumer Reports’ auto evaluation. We can study that car review and know that the characteristics presented will be representative of our future experience if we buy. Not so with investments. That’s why comedians joke about their investments doing well until they bought.

My best example is rebalancing. A sound investment strategy is to allocate assets among a variety of mutual funds, diversifying by investment type (e.g., stocks and bonds) and management approach (e.g., growth and value). The purpose is to capture the benefits of diversification. Then, to maintain that portfolio’s risk level, the investor periodically trims outperforming funds, investing the proceeds into the underperforming ones. This rebalancing restores the allocation to the desired long-term levels. Sounds easy, but in running multi-managed funds (using a diversified group of fund managers), inevitably I was asked “But aren’t you taking from the winners and giving to the losers?” My answer: “No. I am taking from yesterday’s winners and giving to tomorrow’s winners.” And that is how it worked out.

This leads to our second resolution:

#2 – I resolve to use performance numbers ONLY to measure my results. ALL of my investment selection will be based on non-performance analysis.

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