*Excerpted, with additions, from the Wall Street Journal.

We have just begun a new year, which means that it is time for all the performance scoreboards and commentaries highlighting the top-performing money managers, mutual funds, and investment-newsletters of the previous year.

These scoreboards and commentaries can provide some worthwhile information about the previous year. However, be on guard because they can, and most likely will, be hazardous to your financial health.

The reason why you should be cautious in reading these reports is because they incorrectly portray the investment kingpins which they identify based on the previous year’s results.  Sooner or later, but most likely sooner, these investing giants usually incur catastrophic losses making it almost impossible to recover. A better, safer approach is to focus on long-term strategies with histories of beating the market over the long run.

Consider what would have happened if we had constructed a portfolio and then adjusted it each January to contain the previous year’s investment leaders.  According to a study done by Market Watch, this hypothetical portfolio would have lost almost everything. It would have incurred an average loss of 18% per year since 1991.

To put this in perspective, if you invested $100,000 into this portfolio at the start of 1991 and adjusted each year to include the recommendations of each investment newsletter highlighting the top performers of that year, you would be left with just $471 today. If we are to learn one lesson from these scorecards, commentaries, newsletters and ranking services, it would be to run, not walk, away from their recommendations.

Why does this happen?  Why would these publishers get this so consistently wrong?  In hindsight, and logically if you think about it, there are a couple of obvious reasons.

First, these publishers have to make money themselves.  They either have to sell advertising or subscriptions.  In either case, it’s tough to maintain readership, let alone gain readership, if you say the same thing year after year.  In other words, there is a built-in bias to “find” the next great manager, rather than to simply state that the one which was good last year, and the year before, etc. is still going to be good next year.  Most people won’t pay money to be told the same thing over and over again.

Secondly, there is a well-known statistical principal at work here.  It’s known as “regression to the mean.” This occurs whenever extreme data (for example, extremely good performance in one year) naturally returns to its average.   This principal isn’t always at play, so we caution anyone about simply trying to reverse the decision making by assuming that extreme bad performance in any one year means there will be a “reversion” to better performance in the future.  Many times, bad performance occurs because the investment manager is bad.   So don’t try to play statistical games with the data.

The real reason why you should run, not walk, away from the last year’s sweepstakes winner is because many newsletters and investment managers who are striving for the top spot in these rankings pursue wild and risky strategies.  If you compare them all against one another there will always be one who wins big and skyrockets to the top of the annual rankings. However, on average they will lose. Investors who get lucky by picking that lucky adviser are almost certain to trick themselves into believing that lighting will strike the same place twice and that the next year will produce the same fantastic outcome as the previous year.

The real winners are the investment managers who prepare for the long-term. They are less likely to be one of the top performers in any one calendar year, but they are also far less likely to crash and burn.  These managers practice the old adage that slow and steady really does win the race.

The same warnings about the one-year performance sweepstakes apply to mutual funds as well. These statistics can be entertaining and informative about which sectors performed well above average, but for all the reasons cited above, they don’t necessarily translate into superior performance in following years.  In addition, there is at least one other factor at play in the mutual fund world.

These ranking reports typically prompt investors to pour money into the “winning” mutual funds.  If this influx of cash is too large, it actually inhibits the manager’s ability to execute whatever strategy he or she had used to earn the top ranking.  Accepting all that new money (in order to earn greater fees) often means the manager must purchase inferior securities in order to put the money to work.  This drags down performance for the entire mutual fund – for the old and the new investors.

Each year, the S&P Dow Jones Indices puts together a Persistence Scorecard.  This survey isn’t trying to predict who’s on top.  It’s measuring the odds that a given mutual fund will continue to remain above average for several consecutive years – ie, persistency.   Over the many years, the S&P Dow Jones Indices have been producing this report, the statistics show that the probability of a “winning” mutual fund continuing at the top level for several consecutive years is less than the odds of flipping a coin.  The data shows that only 16% of these “top performers” performed the same or better in future consecutive years.

In fact, the data actually shows there is an inverse relationship between the measurement time (1-year vs 2-years vs 3-years, etc.) and the probability of a top fund to maintain their top status.  In other words, mutual funds which did well for 10 years were more likely to succeed in the future than mutual funds which only did well for 5 years;  and 5-year winners were more likely to succeed than those which did well for only 3 years.  As we would expect from this trend, a 1-year historical look-back is going to give us a list of mutual funds with the worst odds of performing well in the future.  The clear lesson from all this is that success comes from focusing on the long-term, not the short term.

But it’s not just an issue of time.  There is no formula which says that if a manager is good 10 years they must be good next year.  Sometimes, it’s just luck.  In analyzing money managers and mutual funds, you have to understand what strategy the manager is following; you have to determine whether this strategy is the cause of the strong performance; you have to be confident that the strategy will be consistently followed in the years ahead; and, most importantly, you must be willing to wait for the long term.

Many managers which have superlative performance over the long term have experienced sub-par performance over a couple of years.  This is natural and should be expected.  To invest successfully, we have to be able to separate short-term aberrations from long-term performance.  Sometimes, short-term performance issues are indicative of a long-term issue, and the manager needs to be replaced.  But more often the short-term performance “problem” is just an aberration and should be ignored.  As we’ve said on these pages before, there is both art and science in selecting investment management.

The annual rankings, scorecards, and awards are never a coronation of kings beginning long-term reins at the top.  They almost always identify the posers and impostors.  Successful management is dependent on long-term thinking which results in a successful strategy that can be repeated, even when the results look a bit bad over the short-term.

The children’s tale about the race between the tortoise and the hare is applicable here, but in real life, it’s a little more difficult to identify the tortoise; it takes rigorous analysis, not just a quick Google search.

 

 

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