Chasing Last Year’s Returns

It is interesting when a client comes in with a chart of some fund or, more recently, bond fund that has performed well over the past year or two and asks why he or she wasn’t advised to invest in that instead.

It is a tough question, and a good one. Bond funds performed steadily during this past bear market. If I had known, I would have been in them exclusively myself. The key word being “known”. I’ll also add that if it were possible to “know” what the markets would do somehow, all financial and market analysts would be multi-millionaires and I would have retired long ago.

Analysts and mathematicians have been toiling steadily for decades trying to determine what makes the market tick so that they could predict, with some accuracy, which sectors would grow or shrink in the future. To date, there have been no sure-fire answers.

This leaves investors to fend for themselves, for the most part, and use their instincts and basic human nature to guide their investment decisions. The most popular manifestation of this natural behaviour is to try what worked before-or more specifically, what worked well last year. We call this “chasing last year’s returns”.

People look at the returns of other investments over the last year and say “If I’d only been in bonds…”. Many people, left to their own devices (without a good advisor) then run to bonds and bond funds because they want the returns that bond funds provided last year.

But this year, what might happen? This year, equities (stock), may do well. If they do, bonds become less desirable and have a lower re-sale value. Interest rates, too, may rise and so bonds held in bond funds will be less desirable, lowering the value of the fund overall.

So someone who jumps from equities to bonds may have double trouble. Not only will they have sold their equities at a market low they may have low or negative growth in bonds. The same thing can happen the other way around. More often, people see a particular stock or equity fund doing well and dump their money in that. Remember BreX?

The results of “chasing last year’s returns” over a long period of time have been charted by analysts. One analysis shows the effect of this strategy over a 10- year period from 1993 to 2003. By moving an initial $ 10,000 investment into a cash or value portfolio based on what performed best the year before, the end result was an annualized 6.3% growth over the period. Not bad? Maybe. A sample balanced portfolio over the same period returned 9.8%. Better? Sure.

Want to get more technical now? The average annual decline in the purchasing power of a dollar over that period was about 1.8%. Subtract that from both returns above and you get 4.5% and 8%. The balanced portfolio did 78% better after inflation!

In short, it’s impossible to predict what the markets will do in the future. Your best strategy is to have a balanced portfolio that reflects your investment horizon and your risk tolerance. An investment advisor can help you establish this balance, and stick to it when the going seems tough.