A few years ago, I was at a conference where another financial advisor asked the speaker about a hot investment trend that “is doing well.” This is a depressingly typical question I hear at advisor conferences, holiday parties and many points in between. But in this case, the speaker happened to be Kenneth R. French – Professor of Finance at Dartmouth College and Director of Investment Strategy at Dimensional Fund Advisors. Without missing a beat, Professor French replied, “That style has done well. But that doesn’t tell us much about the future.”
Fast forward to today’s markets and we discover that some lessons are timeless, including the one about the ongoing dangers of chasing the latest hot performers in the market (or fleeing the recent underdogs).
There are at least two strikes against the advisability of loading up on recent big winners in the market: the evidence and the costs.
Markets: How They Really Work
Decades of practical and academic evidence tell us that chasing market returns hasn’t worked well so far, nor is it expected to work moving forward. It’s also an expensive way to “play” the market. The trades, tax ramifications and other costs involved can really add up, even as they drag down your end returns.
This has to do with how markets actually function. Many investors think the market is the same as a casino game and that it rewards those who are on a lucky hot streak. In reality, markets should be thought of as marvelous exchanges for returning long-term wealth to those who put their financial capital to work in productive businesses.
There are a number of finer points involved – such as the roles that diversification and risk exposures play in managing expected returns. But, bottom line, investors can expect a return on their capital … if they stick around long enough to receive it and keep a sharp eye on the costs involved. This may not be as exciting as a rousing round of roulette, but it’s a far more reliable way to invest one’s life’s savings according to a long-term investment strategy.
Performance Chasing: Unfortunately Alive and Well
Despite the evidence, one does not need to search very far to see that market timing appears to be as popular as it ever was. Whenever a stock, asset class, sector or other piece of the market goes on a winning (or losing) streak, you can almost feel the “whoosh” of undisciplined money chasing after (or fleeing) it.
Why don’t we ever learn? Academics who study behavioral finance point to what is known as recency bias. Our brains are hardwired to assign too much importance to what has happened in the recent past rather than looking at all available information. Over the long term, returns of various equity asset classes (such as Canadian, U.S. or international stocks) have had very similar performance and should have comparable expected returns going forward. But most investors don’t take that long term view: instead, they expect current trends to continue indefinitely. Problem is, asset classes that enjoy several years of outsized returns are expected to revert to average eventually, and there’s no way to predict when that adjustment might occur.
Product follows performance (or lack of performance)
Investors’ own worst tendencies are often further fueled by product providers and others who stand to profit by keeping them in the dark about how to sensibly participate in the market. Falling into the camp of, “I couldn’t make this up if I tried,” an e-mail landed in my inbox on October 14th: NOW TRADING: MULTI-STRATEGY MARKET NEUTRAL FUND. I was being invited to peddle the wares of a strategy purported to make money regardless of the direction of the financial markets. The timing was hardly coincidental, as that very day, Oct 14th, many major global stocks markets had corrected (aka gone down) by 7% to 12% from the recent highs. The fact that most major markets rapidly recovered and then some since then is beside the point. The point is that product providers and marketers are well aware of recency bias and will always be coming up with some investment strategy with outsized performance in the past, whether it is gold, dividend stocks, real estate … the list is endless.
Favorite Timeframe: Never and Forever
Warren Buffett is famously known for having expressed that his favorite investment holding period is forever. When I am asked when is the right time to hold this, that or the other asset class, I like to respond that it is always the right time – if your customized investment plan and evidence-based portfolio call for an allocation to it. If they do not, then the answer is never. To determine what allocations might make sense for you, give me a call. We’ll arrive at the right number for your long-term financial goals.