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Are You Confusing Hindsight With Insight?
The Temptation of Past Performance
 By Ernie Ankrim, Chief Investment Strategist
Russell Investment Group
Global Leaders in Multi-Manager Investing
November 2, 2004
This article has been provided by our parent company, and any references to rates or returns are based in $US and specifically relate to US markets, unless otherwise specified.
The past few years have been a powerful, and sometimes painful, reminder of the key truth about selecting asset classes to invest in. What worked yesterday may not work tomorrow.
This is, of course, a familiar observation. US-based regulatory bodies such as the SEC and NASD require disclosures like "past performance is no guarantee of future results" with good reason. Yet investors often persist in believing that past performance is an accurate market predictor, because for some reason the current situation is a "different story."
Today's humbling observation is that investors often fall on their faces when they try to be too smart. In particular, there are three dangerous behaviors:| |
- Mistaking temporary trends for "new market directions"
- Basing tomorrow's strategy on today's asset class "winners"
- Letting a sudden "insight" lead to chasing performance
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Musical Chairs
The table shown here illustrates how five different asset classes take turns at holding the best-performing (blue) and worst-performing (gray) distinctions. What is most interesting is that the most devastating asset class of 2000-2002 was the same asset class that had been the best performer over the previous six years.
How Asset Classes Continually Switch Places
Two-year annualized returns ending Sept. of:
R1000® = large-cap stocks; R2000® = small-cap stocks; EAFE = non-U.S. stocks; LB Agg = bonds; NAREIT = Real Estate Investment Trusts
It is likely that the run up in large-cap U.S. equities we saw prior to 2000 caused many investors to change their views on markets and increase their willingness to take on risk. But would so many people have lost so much money if, say, the decline of 2000-2002 had been preceded by a period like 1994 with 9% returns? It's unlikely that a 9% return in 1998 and 1999 would have attracted so much attention that investors would have dramatically over-allocated their portfolios to large-cap growth funds.
The same could be said of the Canadian stock market, where investor exuberance produced an average return of 19.6% between 1999-2000. This was followed by an average loss of 12.5% between 2001/2002, as investors who were not properly diversified across all asset classes paid the price.
So while there will always be movements in markets that in retrospect look like "trends," a better term might be "outcomes of random markets." It's rarely the case that these short-term vagaries indicate we should modify our portfolios.
Balance Trumps Insight
This is why the recent performance of one asset class — REITs — may be near the lead through 2004, but is raising a warning flag. From 1990 to 2004, REITs are the only asset class among the five that doesn't have the distinction of being either the best or the worst performer over a two-year period. The Russell 2000 was the best two times and never the worst (although sometimes one of the worst.) Non-U.S. stocks measured by the EAFE, large-cap U.S. stocks measured by the Russell 1000, and bonds measured by the Lehman Brothers Aggregate were both best and worst.
REITs, as measured by NAREIT, were by far the best performing asset class over the past four years. However, this powerful performance strikes me as another temptation for people to believe that this is a different phenomenon than we've seen before and as a result is likely to continue. I'm particularly concerned that this year, I've seen more covers of popular investment magazines featuring REITs in their headlines than I have in all my years at Russell.
Lessons Learned
If we've learned anything over the past years, it's a good idea to hold a lot of different things but you don't want to chase anything — not large-cap, small-cap, non-U.S., bonds or even REITs.
Following a balanced strategy affords investors the opportunity to be fairly compensated for taking on risk but never subject to the possibility of having the worst-performing asset class dominate their portfolios over any short period. When the next two-year period chart appears in 2006, you may not have all your assets in a blue box, but you won't wind up having most or all your assets in the gray box.
And I think that's what all investors really want; a long-term strategy that allows assets to grow at an inflation-beating rate, with tolerable volatility.
Above all, a balanced approach helps avoid paying dearly by mistaking hindsight for insight. The only thing past performance tells me is how nice it would be if I could go back four years and invest all my money in REITs.
Copyright© Frank Russell Company 2004. All rights reserved. See Important Legal Information. First used: 11/12/04.
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