Past Performance is No Guarantee of Future Results How Chasing High Returns Can Cause Problems for Your Portfolio
Friday, March 21, 2014
Famed hockey player Wayne Gretzky summed up his secret to success when he said, “go where the puck will be, not where it is.” When analyzing a company or mutual fund, many investors would do well to heed the same advice. Instead, they suffer from what is known in the business as “performance chasing”. As soon as they see a hot asset class or sector, they pull their money out of their other investments and pour it into the new object of their affection. The result is much akin to someone chasing lighting – they go where it has struck and then wonder why they continue to compound at lower than average rates of return; a tragedy that is exasperated by frictional expenses.
As the late Benjamin Graham, father of value investing, pointed out to his readers, past performance is useful in calculating the value of a stock, bond, mutual fund, or other asset only so far as it is indicative of what is to come in the future. Often, the very best time to invest in a particular area is when it has suffered from horrific industry trends over the recent past. Take the oil sector, for example. In the late 1990’s, black gold was trading at $10 a barrel and very few analysts saw an end to the energy sector’s woes. Yet, over the past six years, an investor in refiners such as Valero or an integrated giant such as Exxon Mobile have experienced wonderful returns.
How can you help ensure you aren’t guilty of jumping into a hot sector? Ask yourself the following questions.
- What makes me think the earnings of this company will be materially higher in the future than they are at the present time?
- What are the risks to my hypothesis of higher earnings? How likely is it that these theoretical riskswill become actual realities?
- What were the original causes of the company’s underperformance? If it was in any way linked to aggressive accounting, what makes you sure that the situation has been permanently resolved and integrity restored to the firm? If it was an industry specific problem, what makes you think that the economics going forward will be different? A temporary supply and demand situation? Lower input costs?
- Has this particular sector, industry, or stock experienced a rapid increase in price in recent history? Knowing the principle that price is paramount, does this still make the investment attractive? Have the prospects for better earnings already been priced into the security?
