Don’t Chase the Hot Dot—How We Invest, Part Three

It’s so obvious that you may not have even noticed it. It’s the paragraph that is part of the paperwork for every investment account that you open with an advisor, brokerage firm, bank, or insurance company. It makes so much sense that you acknowledge it and move on, barely giving it a thought. It’s obviously important because sometimes it’s in ALL CAPS. I’m referring to the part of the contract that says, “Past performance is not a guarantee of future results.”

We inherently understand this and know that it’s true. We know that the markets change every year. We know that last year’s best-performing investment may be this year’s laggard. Some years, stocks provide a better return than bonds; sometimes bonds do better than stocks. Large company stocks can outperform one year, and small company stocks lead the way the next. International stocks are this year’s star and next year’s dud.

We know that investments work this way, yet when it comes to managing our portfolio, lots of folks seem to come up with a bad case of amnesia. When selecting investments, too many of us make the decision on whether to add an investment to our portfolio by looking at the recent performance. This seems to be the case whether it’s a stock, a mutual fund, an exchange-traded fund (ETF), or another type of investment vehicle. If it has done well recently, we’ll add it to our portfolio mix. If it hasn’t done well, we tend to avoid it.

This behavior is known in the industry as “Chasing the hot dot.” We know that last year’s winners are often this year’s losers, but many of us seem unable to transfer this knowledge to action when selecting our investments. I see this most often when people are choosing the investment mix for their 401(k) plans at work. They’ll look at the menu of funds available to them in the plan and choose the ones that have the best performance numbers over the last six months or a year. This is not how to choose your investments.

I have a chart I like to use when explaining our investment strategy to clients. I call it my “Skittles chart” because it’s very colorful. It assigns a bright color to all the asset classes that we use when building our model portfolios. For example, U.S. stocks might be a shade of blue, international stocks might be yellow, emerging markets might be red, and short-term bonds might be green. The chart then ranks the asset classes based upon their performance each year. The result is a quilt-like pattern of bright colors, reflecting how each asset class has done each year relative to the others.

When discussing the chart, I’ll point to 2007, which shows that emerging markets were the top-performing asset class, returning 39.4% for the year. I’ll explain that many people would look at that return and make the decision to add it to their portfolio because it was doing so well. Of course, in 2008, emerging markets were the worst-performing asset class, losing 53.3%. The poor investor who bought the fund at the beginning of the year gets to the next year and says, “Well, that didn’t work out.” So, the fund is sold. And of course, in 2009 emerging markets returned to the top of the performance list with a gain of over 78%. So now the investor, who bought when the price was high after 2007 and sold when it was at a low in 2008, has another chance to buy high. Buying high and selling low is not how to win at the investing game.

A better approach is to make sure your portfolio is diversified across the major asset classes. If you owned emerging markets in 2007 and you enjoyed a 39% gain, you would rebalance your portfolio and sell a bit of it (but not all) when the price was high. Then, after the asset class lost 53% in 2008, you would rebalance again and buy when the price was low. Buying low, selling high—that’s how you are supposed to invest.

When it comes to building your portfolio, just remember that funds that have outperformed in the past do not always keep on winning. Past performance provides little insight about how that fund will perform in the future. That’s why that paragraph is in every investment agreement. It’s so obvious.