Tuesday, January 8, 2013

Investment Performance

              As we close the books on 2012, the financial press is rife with report cards on investment performance for the past year.  What information do these report cards convey with respect to common stock investing?  Virtually none whatsoever!  The stock market is sufficiently volatile that one year’s performance conveys about as much information as the first play of a football game conveys about the game’s future outcome.

              To be a bit more precise, consider how many years of data are required to conclude with 95% confidence that the return on the S&P 500 index exceeds that on ten-year Treasury bonds.  Of course, theory predicts that the riskier stocks offer higher expected returns, but how much data is required to confirm that prediction empirically?  The answer is close to 50 years!  Few investment managers have such long track records and those that do are unlikely to have followed the same investment strategy the entire time.

              Despite that fact that it conveys little reliable information, it is still fun to keep track of who wins and who loses on an annual basis.  The danger is the temptation to begin acting as if this information were meaningful.  More specifically, the risk is that individual investors end up chasing the performance guru du jour.  Such tail chasing is a mistake for two reasons.  First, moving money around can get expensive because of the transaction costs.  Second, recent big winners tend to respond by charging higher fees, so chasing winners means paying higher fees for, well, nothing.

              In short, as the year ends enjoy the avalanche of annual investment performance reviews.  Just don’t take any of them too seriously.

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