We’re all familiar with the following disclaimer: Past performance is not indicative of future results. It is attached to virtually every investment vehicle. And yet, how many investors take its message to heart? Unfortunately, very few. In fact, the first thing most investors scrutinize in a potential investment is past performance. Most investors are probably familiar with Morningstar ratings, where it assigns a mutual fund anywhere from one to five stars based primarily on past performance. The better the past performance, the more stars it is given.
Now, if past performance was predictive of future returns, acting on this rating system would make perfect sense. But alas, it is not. There is no evidence that the top-rated funds over the past three years will outperform over the next three years. A 2010 study by Vanguard, “Mutual fund ratings and future performance,” actually showed the opposite to be true. On average, the funds with a one-star rating outperformed the funds with a five-star rating over the subsequent three-year period.
If this is the case, why do most investors, both retail and institutional, continue to chase past returns?
Well, we are all human beings hard-wired with certain attributes. One of these is what is called “herd behavior,” or the tendency for individuals to mimic the action of a larger group. Herd behavior occurs due to our innate desire to conform and our perception that a large group is less likely to be wrong than a single decision maker.
For retail investors, a tendency to follow the crowd is understandable. They have no experience or expertise in evaluating potential investments and will naturally gravitate to what has performed best in the recent past. Of course, what has performed best in the past will be quite popular with the crowd. One would expect institutional or professional investors to have more savvy when it comes to avoiding herd behavior but for most, this expectation falls short. Additionally, fund managers suffer from conflicts of interest, known as “agency” issues. The primary conflict for most managers is something known as “career risk.”
Career risk is the dirty little secret of the investment business. If a fund manager conforms to his or her peers by mimicking the average portfolio and loses a lot of money, the losses are generally forgiven. On the other hand, if a fund manager actively goes against the crowd and takes a more cautious stance while the market rallies, this can be a career-ending move. Fund clients tend to have little patience when short-term performance deviates widely from the crowd, even if it is in their best long-term interest.
We saw this with many conservative funds in the late 1990s, as value-conscious managers were penalized for not participating in the dot-com bubble. Their clients withdrew their assets in an effort to chase performance in other tech-heavy funds that paid little heed to fundamentals. Come October 2002, after an almost 80 percent decline in the tech-heavy Nasdaq, conservative funds were back in vogue. Of course, this was just in time for the next bull market when aggressive funds once again began to outperform.
What can the average investor do, then, to avoid the negative effects of herding and save more money for retirement?
1. Develop an investment plan and stick to it, ignoring the latest fads and recent performance trends. In today’s market, that means avoiding the lure of high-flying social media companies and other technological marvels (electrically powered cars, 3-D printing, solar power companies, etc.). For most individual investors, a simple rule of not investing in individual stocks will keep them out of a lot of trouble.
2. Outsource the investment decision-making to a trusted advisor. We all have the urge to sell low and buy high. For many, having an extra layer between you and your investments is the best way to prevent you from acting on these urges.
3. When choosing a fund, look for managers with a strategy and process that is less inclined to simply follow the crowd to avoid career risk. At Pension Partners, we utilize a quantitative, model-driven investment process for this very reason. Using such an approach takes the emotion out of the decision-making process. It maximizes the long-term, risk-adjusted returns for investors. If that means underperforming in the short run by not conforming to the crowd, we have to accept this risk and stick to our process.
4. On the margin, look for contrarian opportunities at extremes. Individual investors have a distinct advantage over professional managers in that they can do this without having to worry about career risk. In today’s market, a good example of such an opportunity is the wide divergence in performance over the past three years between U.S. small caps (up 52 percent) and emerging markets (down 8 percent). This spread has left emerging markets significantly cheaper than U.S. small caps on a valuation basis and more likely to outperform going forward.
Michael A. Gayed, CFA, is a chief investment strategist and co-portfolio manager at Pension Partners LLC, an investment advisor which manages a mutual fund and separate accounts according to its ATAC (Accelerated Time and Capital) strategies focused on inflation rotation. In 2007, he launched his own long/short hedge fund, using various trading strategies focused on taking advantage of stock market anomalies. Follow him on Twitter @pensionpartners and YouTube.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.