From the Archives: Performance Chasing

November 21, 2011

Jason Zweig, in an interview with Morningstar, points out that performance chasing is seen in all parts of the investment world:

There was a beautiful study that was published in the The Journal of Finance a couple of years ago about the selection of institutional money managers. It basically found that the professionals who pick money managers, in this case it was pension funds, tend to buy high and fire low. They invest in whichever managers have the best trailing three-year performance and then sell whichever have the worst trailing three-year performance. The study showed that if they had flipped their decisions–if they had bought the ones with the worst three-year performance and sold the ones with the best–they actually would have gotten better returns. And of course if they had done nothing–if they had just put the portfolio on ice–they also would have done better. Performance-chasing, despite all the propaganda you hear in the financial industry, is not purely the province of retail investors. It’s not the so-called “dumb money” on Main Street that buys high and sells low. Everyone does it.

You have three choices: you can go with a manager when they are hot, you can go with a manager when they are cold, or you can do nothing. Investors, in aggregate, make the worst choice of the three! If you don’t have the emotional resilience to go against the grain, at least have the patience to sit on your hands.

—-this article originally appeared 10/23/2009. We’re a couple of DALBAR reports down the line and investors, in aggregate, continue to make the worst possible choice. Your best bet is to pick a sound strategy and add to it during periods of underperformance.

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Bold Recession Call

November 21, 2011

Back in September, the Economic Cycle Research Institute (ECRI) announced publicly that the US was headed into a recession. Advisor Perspectives carried the article:

Today the ECRI publicly announced that the U.S. is tipping into a recession.

Early last week, ECRI notified clients that the U.S. economy is indeed tipping into a new recession. And there’s nothing that policy makers can do to head it off.

ECRI’s recession call isn’t based on just one or two leading indexes, but on dozens of specialized leading indexes, including the U.S. Long Leading Index, which was the first to turn down — before the Arab Spring and Japanese earthquake — to be followed by downturns in the Weekly Leading Index and other shorter-leading indexes. In fact, the most reliable forward-looking indicators are now collectively behaving as they did on the cusp of full-blown recessions, not “soft landings.”

The graphic attached looked very convincing.

Bold Recession Call

Source: ECRI, Advisor Perspectives

Now that we have the additional perspective afforded by time in mid-November, a couple of things are apparent.

1) It’s possible we won’t have a recession at all. The Leading Economic Index has continued to rise and, if anything, the economy has appeared to accelerate slightly.

2) Even if we are still on a path to a recession, markets have not responded in a way that would be expected. For example, since September 30 the best performing domestic sectors have been energy, basic materials, industrials, and consumer discretionary stocks—exactly what you would expect for an economy in expansionary mode. The worst performing sectors have been telecom, healthcare, utilities, and consumer staples—exactly what should do well in a recessionary environment.

Source: Dorsey Wright Money Management

I’m not trying to pick on ECRI here. They know far more about economic forecasting than I ever will. In fact, they’ve probably forgotten more than I ever learned. ECRI is clearly credible or no one would pay attention to their forecast in the first place—they’ve had many successful forecasts in the past and they’ve earned their credibility.

I’m just trying to draw attention to how difficult the forecasting game is. ECRI has access to good data and trained economists with a lot of experience, something that a retail investor will not be able to recreate—and they still make mistakes. For the typical investor, using relative strength in a systematic way is likely to be a more fruitful approach to investment than relying on even an expert forecast.

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Weekly RS Recap

November 21, 2011

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile and quartile and then compared to the universe return. Those at the top of the ranks are those stocks which have the best intermediate-term relative strength. Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (11/14/11 – 11/18/11) is as follows:

High relative strength stocks held up better than the universe and better than the laggards in a rough week for the markets.

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