At the bottom of this page and at the bottom of virtually every piece of literature that references investment strategy, investment products, investment firms, etc., you will see a disclaimer clearly stating that past performance is not indicative of future results. Yet, what is the first thing most people look at when comparing investment vehicles? Track record. Past performance.
We would all like to believe that we can glean some insight into future investment returns by looking into the past, but does it really work that way? I am reminded of the daughter of a client that was hired by a futures brokerage firm upon graduating from college. Rather than harnessing her powers of logic and keen intellect, the firm wanted her to make cold calls to potential clients in an interesting, albeit disheartening, manner. Starting with a large list, she was to call half the names with a free tip to go long (a bullish position) a certain futures contract (soybeans or swiss francs or pork bellies, etc.). Then she would call the other half of the list with a free recommendation to short (take a bearish position) the same contract. Half the list was bound to get a recommendation that worked! She would then take the list of ‘winners’ and give them a second tip in the same way – half long and half short the same contract. This pattern would be repeated four or five times until an impressive track record was established for a lucky few. Consider the following:
- Start with 1000 names.
- After the first call she has 500 winners
- After the second call she has 250
- After the third she has 125
- After the fourth she has 62
With the massive amount of leverage embedded in a futures contract she may now call those four-time winners a fifth time and legitimately claim that an initial investment of $10,000 could be worth millions today if only they had followed her advice. How can you argue with a track record like that? It’s a pretty effective strategy for recruiting new business, but obviously a lousy strategy for making money in the futures (or any other) market.
How different is this from the advertising of various types of investments we see in magazines and newspapers? Let’s assume a universe of 2000 different growth portfolios. Of those that advertise very good three or five year track records, isn’t it likely that some of them, like our four-time winners above, were just lucky? Out of the 100 names that would make up the top 5% for any given time period, isn’t it likely that at least a few of them achieved that rank out of serendipity? If you accept that premise, how could you ever know which managers were lucky and which might have the skill to persist as a top performer?
Take the case of Bill Miller. Mr. Miller is the very well known manager of a large cap growth portfolio that had the distinction of beating the S&P 500 for fifteen consecutive years (1991 – 2005). His success attracted thousands of investors and billions of new dollars to manage. Mr. Miller was celebrated in the industry and by the media as a genius and an exceedingly rare talent. In 2006 his streak ended and he underperformed the market in both ’06 & ‘07. As of this writing (8/19/08), he is down more than 29% for the current year, while the market is down about 13%. His trailing 10 year track record is now well below that of the S&P 500. What happened? Has he lost his touch? Did he ever really have it in the first place?
Unfortunately, it appears that the disclosure statement might really be true. Past performance may not be indicative of future results. In addition, investors should be aware that past volatility and past correlations between different asset classes are also not indicative of future results. Without knowledge of the process that produced the results you are looking at, a track record may not be telling you what you really need to know.
Disclosure: Past performance is not indicative of future results. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. Ideas and opinions expressed in this article are the sole responsibility of Patrick Crook/PLC Asset Management and do not reflect any stated opinions of Commonwealth Financial Network, National Financial Services or any other person or entity.