Stock
Watch
The Primrose Path
The top performing portfolio last year, among the more than 500 recommended by the investment newsletters tracked by the Hulbert Financial Digest, gained 75.5 percent.
That’s certainly an impressive number, isn’t it?
Compounded for 10 years, such a growth rate would turn 25,000 dollars into nearly 7 million dollars. Investors, who were postponing retirement because their 401(k)s had been devastated by the bursting of the Internet bubble earlier this decade, might be able to retire on time after all. Don’t, for a minute, think that you can consistently attain returns this large, however.
If the past is prologue, your 25,000 dollars will not come close to 7 million over the next ten years by following the previous year’s top performer. On the contrary, such a strategy will shrink that 25,000 dollars to just 1,526 dollars.
Consider the results of a hypothetical model portfolio that, each year, exactly mimicked the newsletter model portfolio that had the best return in the previous calendar year according to the Hulbert Financial Digest. Over the last 16 years, this portfolio produced a 24.4 percent annualized loss.
That’s 33 percentage points per year below what you could have achieved simply by buying and holding the stock market itself, as measured by the Dow Jones Wilshire 5000 index.
The conclusion from these results should be abundantly clear: The strategies that are at the top of the one-year leader board are exceedingly poor bets for future performance.
You’ve no doubt heard many times that short-term performance amounts to little more than statistical noise. But, all too many investors continue to be seduced by the allure of the huge returns that some lucky advisers were able to produce in the recent past. Just as a gambler’s attention is inexorably drawn to the slot machine where a jackpot has just occurred, too many naïve investors can’t help themselves from following the lead of the adviser who has recently done well.
In fact, some psychologists believe that this habit of thought is far more widespread than just among investors and gamblers. Researchers refer to it as the “recency bias” -- the tendency to place disproportionate weight on more recent events than on what has happened in the more distant past.
To test whether you are immune to recency bias, consider what you would do when choosing between two hypothetical newsletters identical in all respects but one: The trailing-year performance of the first is far better than that of the second. Would you choose the newsletter whose recent performance is the best?
As you consider your answer, bear in mind that I have constructed this example so that both newsletters have identical long-term records. The only difference is that the first newsletter’s best years came more recently than those of the second.
If you think that the first newsletter is a better bet, you are guilty of recency bias. I am unaware of any research showing that the order in which an adviser turns in his best years is relevant to a bet about how well he will do in the future.
By the way, don’t think for a minute that because the last year’s top performers proceed to perform so poorly that you would do any better by investing in last year’s worst performers. You wouldn’t.
Consider a hypothetical portfolio that, instead of following the investment letter portfolio with the best returns in the previous calendar year, mimicked the portfolio that was the absolute worst performer. Instead of producing a 24.4 percent annualized loss over the last 16 years, as was the case with the previous year’s best performer, this loser’s portfolio did even worse -- producing a 58.4 percent annualized loss.
For all intents and purposes, of course, that’s a complete and total wipeout.
The bottom line? One-year results are little more than statistical noise. Choosing your adviser on the basis of them is folly. Focus instead on results over the long term.
Mark can be contacted via email at mhulbert@marketwatch.com.
Subscribers to Hulbert Interactive (the premium section of the MarketWatch website based on the Hulbert Financial Digest data) can access the complete Hulbert Financial Digest Honor Roll for 2007 by clicking here.
To find out more about Hulbert Interactive, click here.
