They say that hindsight is 20/20. This means that you can see perfectly when looking backwards. If looking backwards made you wealthy then historians would be the richest people in the world. They’re not. To create wealth you must look forward. I like to think that the past is like reading the rulebook for the game you are playing which in this case is the investing game. It’s not necessary, you can just jump right in and learn along the way, but if you learn the past it can save you from making a lot of costly mistakes and it establishes accurate expectations. Establishing accurate expectations is important or else you will have unrealistic expectations that can lead to bad behavior. By bad behavior I mean unrealistic expectations can lead you to change an approach that is working or about to work for something that probably won’t. The grass is not always greener.
Let me give you an example. Despite my advanced age of 50 I am still a pretty good golfer at times. When I’m playing well and all the stars are aligned I can shoot under par for 18 holes. One time I was playing particularly well and I went to see my instructor for a lesson. I like to take golf lessons when I am playing at my best so that I can ingrain those good thoughts that are working. I also take lessons when things are at their worst so that I can exorcise the demons. My instructor is an expert and one of the best in the country. Read An Expert Tale to understand the value of expertise. I explained that I was playing well and wanted to tighten up my driving accuracy.
He asked me to try something. He had me hit 14 simulated tee shots with my driver, the same number of tee shots you might typically hit over the course of 18 holes of golf, and we kept track of them. When we finished, I had hit them all over 270 yards. I had hit 9 in the fairway, where I was aiming, 3 in the right rough and 2 in the left rough, where I wasn’t aiming. I turned to him in disgust with my performance and said “You can see the problem can’t you? I can’t hit it in the fairway consistently. I need to hit at least 12 fairways and when I miss-hit it I need to be certain to always miss either to the right or the left. Because he is an expert on golf and has mastered what a golfer can expect he looked at me and said, “Carlos, if you could do that you would be the greatest driver of a golf ball that ever lived.”
I quickly got his message. In trying to improve something that wasn’t broken I was putting myself in danger of breaking the very thing that didn’t need fixing. Investing is very similar. History is our guide and teaches us what is reasonable, what is world class, what world class looks like, what stinks and what stinks looks like. As an investor you should always be aware of your investment skill level and if you hire an advisor you must be aware of their investment skill level. Most investors and advisors have very little skill and becoming or finding one that does is much harder than finding golfers that can shoot under par. Fortunately as we learned in A Tale of Diversification, if we practice diversification our skill level at investing doesn’t have to be nearly as high as our skill level would need to be in golf in order to shoot par. But beware, if you try to do more than you are capable the bogeyman or the double or triple bogeyman will get you. In the words of Inspector Callahan of Dirty Harry fame, “A man’s got to know his limitations.”
So why is this A Tale of Hindsight other than what we should learn from history? What happens if you use the past to predict the future? This is one of my favorite topics and area where I have devoted thousands of hours of research. In the case of most investors, chasing past performance means that you will either lose a lot of money or under-perform miserably. Don’t do it unless you can develop a way to chase past performance consistently and in a disciplined manner. You can read A Tale of Persistency to see an approach that I find works for me. It is a quantitative approach and many people will be unable to trade it themselves which is why I have no problem divulging the secrets of persistency. I am a firm believer that successful investing or trading is much more about consistency, discipline and finding an approach that psychologically suits your personality than anything else. I am confident in my approach, I have traded it and it suits my personality. Most importantly, I am capable of sticking to the rules even when things aren’t going as well as other approaches. An understanding of the past lets me know what to expect in the future. Hindsight gives the disciplined investor confidence.
This tale also teaches us one of the ways that people interpret history incorrectly. Every mutual fund and investment you will ever review will say somewhere that past performance is no guarantee of future results. It is so generic that people don’t pay attention to it. Recognizing the flaw of chasing past performance is something I consider one of the most important lessons an individual can learn. If you invest today based on yesterday’s top performers with the expectation that they will continue to perform well forever you will lose. Many academic studies as well as many successful investors recognize that past performance is in fact a harbinger of future performance. However, it isn’t forever. It is for a time period but not forever. If you don’t know what this time period is, don’t chase past performance.
Before you go any further in this tale I want you to stop and think about what the phrase “Past performance is no guarantee of future results” means to you. Do you interpret it as a good or a bad? Do you immediately think, I should avoid this investment? Do you think you should be attracted to this investment? Do you just gloss over it? Please stop and think for a few seconds. No kidding, pull away look up at the ceiling and answer this question truthfully.
Here is what I think. I think most people don’t even pay attention but if they do they consider it a positive instead of a negative. It isn’t a warning. I almost think the regulators deliberately chose the wording in order to make people think that it was a good investment. I know that when people hear the phrase, especially about a fund that has performed spectacularly in the past, they say to themselves “I don’t expect to get those results but I’ll be happy with a fraction of the results.” Every sales driven advisor or SAD sells or has made a sale based on this faulty logic and deceptive sales tactic. I know I was guilty as charged myself back before I knew better. This is the way most investments are sold in this country, and it’s not just the SADs that do it. Plenty of fee driven advisors or FABs fall into the same trap. Hired asset managers or HAMs do it too. This is the way most mutual funds and other investments are sold in this country. This is the way most people select their own investments. This is the way most people lose money. Again, don’t be a pigeon. If there is anything you do, avoid investing in superior past performance unless you know for how long superior past performance lasts.
Like most things you don’t have to take my word for it so I’ve borrowed a table from Lipper and the Bogle Financial Research Center. It’s great. It looks at the 7-year period from 1993 to the end of 1999 and selects the 5 best performing mutual funds and ranks them from 1 to 5. These are the very best out of 424 that by 1995 had over $100 million in assets that they were managing. It then looks at what would happen to your money if you had invested in these 5 top-performing funds at the end of 1999 and held them through the year 2005. This is a perfect example of using past performance as a guide to your investing. What happened? Not one of the funds made you money. 4 of the 5 lost you more than 35% of your money and one lost you almost 65% of your money. Not one of the funds was ranked in the top 200 by the end of 2005.
Why Chasing Past Performance Stinks
Throughout these tales I have said that chasing past performance is a flawed methodology. Yet, even amongst the allegedly smartest managers and consultants, we find that they do it too and they also suffer inferior results due to their folly. You will feel the effects of chasing past performance on your portfolio so avoid it. As I’ve said before, identifying a superior investment manager is difficult. They exist but most individual investors won’t find them. Investing is not the same as being a historian. The probability of your SAD or FAB finding them is higher but not much higher. The probability of a HAM finding them should be higher since they have all their resources devoted to this task and yet they find so few. When they do, many of these gifted investment managers fly the coup and head for greener pastures where their skills can be more richly compensated as hedge fund managers. The game of identifying superior managers is not an easy one. If you do you must look at the methodologies employed by the manager and stay with them through multiple cycles.I won’t get into more detail since this tale is already too long and tales should be short. But as I mentioned in A Two Timing Tale, the Morningstar firm has developed an excellent metric to measure what actual investors make in a fund. It is called Investor Return. It is the first metric in my opinion that investors should look at before investing. I think it is a mistake to look at what an actual fund does and expect that you will do the same. Look at what people that invest in the fund do and expect that since you are like most people you will make the same mistakes they made.
In closing, let’s look at the performance of the Legg Mason Value Trust. This fund had a record of beating the S&P 500 for 15 straight years from 1991 through 2005. It is run by what many consider to be one of the best investors of our times. This is the same investor however that people are firing because of his short-term underperformance over the last 3 years as of this writing. In fact the fund he manages has lost almost half its’ assets either from losses or withdrawals. The fund is not alone in that many value investors, investors that buy stocks with an intrinsic value greater than their current market value, have been suffering. The point of this is that I seriously doubt that one of the greatest managers of our time had lost his touch or that his record was just lucky. Nevertheless from the perspective of a long-term investor and this tale, if you invested based on past performance you are out of luck. Let the past be your guide but don’t let it dictate the future.