As human beings we love to follow trends. The hot team going into the baseball playoffs is always a favorite for everyone picking a World Series winner. It is ingrained in our thought process that past performance can be used to predict the future. This line of thinking is often employed when trying to predict the stock market, which all signs point to being a near impossibility. I decided to run some numbers using a defined set of asset classes (the chart I used is included below), to see what would happen if we tried using past performance as an indicator for future performance. What I found on the face, was a bit surprising, but the more thought you put into it, the more it makes sense.
By using 1999 as my base year, I ran numbers on what would have happened had you bought $1,000 worth of the best performing asset class from 1999 on January 1, 2000. In subsequent years, if you would have taken what you had at the end of the year from the prior investment and invested that in the best performing asset class, year after year until 2013 your $1,000 initial investment would have turned into just over $946. I just threw a lot of dates and numbers at you, but suffice it to say most investors would not be pleased with that kind of return over a thirteen-year period.
I then ran the numbers if you would have done the opposite and purchased a fund representing the asset class that performed the worst in the prior year, with the same parameters as above. The results in this case were much more favorable, resulting in the original $1,000 investment turning into $2,501 at the end of thirteen years. Obviously this was a much more favorable outcome, and equally as obvious is the fact that short-term past performance doesn’t mean a whole lot when trying to predict next year’s performance.
Now would be a good time to transition into a talk about risk. I would never advise someone to employ the strategy above, largely in part to the risk of holding your entire portfolio in one asset class, i.e. emerging markets, international stocks, or the US market. Another reason I would advise against this strategy relates back to the underlying premise of the first three paragraphs; past performance is not necessarily an indication of future returns. Managing risk is one of the most important factors in the portfolio building process. The average investor would probably define risk as what portion of your portfolio is in the stock market, and while market risk is a big factor, there are many more types of risks investors need to worry about. Inflation risk, interest rate risk, political risk, industry risk, and the list could go on forever. As we have learned, risk and return are directly related, if you want higher long-term returns, you have to take on more risk. The way to achieve a proper level of risk in your portfolio would be to first figure out the amount of market risk you should take for where you are in your “investment time horizon.” Once you have managed the market risk to an appropriate level, you can attack the other types of risks by constructing a well-diversified portfolio using the various global asset classes available.