The marginal investor: thoughts from the edge

Getting past past performance

Jack GrayIn his blog on outlying investment issues, Jack Gray Adjunct Professor of Finance at the Paul Woolley Centre for Capital Markets Dysfunctionality at the University of Technology, Sydney, contemplates the allure of past performance.

Even the most hard-bitten and cynical among us are struck by the unyielding power and influence of past  performance. We’re familiar with how the bulk of fund flows go to US equity mutual funds with 4 or 5 Star ratings from Morningstar, and equally familiar with the brevity of listed equity outperformance.

“Sophisticated” investors also yield to the power. A recent survey asked the largest 500 European companies about hedge funds. Over the past two years, as performance deteriorated and redemptions increased, perceptions of hedge funds deteriorated in sympathy. In 2007, 46 per cent of companies agreed that hedge funds are the “most intelligent and informed investors”.

By May 2009 only 29 per cent agreed. As goes past performance, so goes assessment of intelligence, in spite of an almost certain increase in the IQ of survivors in this the most Darwinian of all markets. Meanwhile, investors seem to have a different view. The past few months of strong hedge fund performance has turned the tap back on, the drought in hedge fund flows may be over.

We”re all vulnerable to reading the past as prologue, in investments, in our personal lives, and in politics. The all too common belief that the poor will always be with us rests largely on their (so far) having always been with us. We shouldn’t and can’t totally avoid using past performance, and none do. It can be used in intelligent, sensitive ways, to help investor’s decision making, and in misleading, persuasive ways to improperly influence them.

We do warn investors of the pitfalls, but inadequately so.

We derive immense comfort and legal protection from the rational-sounding standard slogan, “past performance is not indicative of future performance”. Yet we know it makes nary a dent in investor behaviour.

Peeling back the whitewash reveals the underground slogan “past performance rules, OK?” that is whispered furtively between consenting adults. And it will always be so.

In all other of life’s activity, past performance is a useful and somewhat reliable predictor of future performance. This heuristic, or “rule-of-thumb”, is far from perfect, but it ain’t half bad. Relying on heuristics to navigate through the complex fog of existence has served us well along our evolutionary path. Long before Newton, long before we understood ‘why’, when all we had was past performance, we extrapolated that past and based our lives around a rational expectation of the sun rising tomorrow.

The ancients also sensibly returned to hunt where they had past success. A few tribesmen may have pondered the heuristic’s efficacy, seeking context, understanding, and signals of potential change because mammoths (and alpha) suffer the tragedy of the commons. To the tribe’s singular advantage, pondering improved the heuristic’s reliability. Would that investors too saw pondering as a source of added value.

For surgeons, and builders, and pilots, past performance is a strong indicator of future performance, as it is in sport and the weather. In each instance, conditional on having no other information, past performance remains a good, if not the best predictor of future performance.

The standard slogan denies investors the (false) security of the past-performance heuristic, a security born of its success elsewhere. Our mistake lies in not replacing it, in leaving investors with no guiding framework other than the admonishment “don’t”. People reduce the consequent and predictable anxiety by returning to that which has served them well…in the past. That’s the ancient ‘us’.

The post-modern ‘us’ live in a relativised world where absolute bans, sans mitigation, induce disbelief and skepticism. Indeed, the standard absolute warning about past performance, one that none read and even fewer pay attention to, (intentionally?) overstates the case. Thanks at least to momentum investing, there is some slight persistence in performance, so it might sometimes be indicative of future performance.

All said, a more apposite warning would read:

“Only rarely should past performance be a dominant selection criterion; it should never be the sole one. In some
contexts, past performance can be a partial indicator of future performance, provided it’s used with intelligent and sensitive discretion and an awareness of the factors that can affect and change performance.”

By design, that warning is too clumsy, too conditional, and too complex a slogan to daub on walls or to tattoo on arms. Moreover, it demands context-dependent interpretations, which is precisely why it comes closer to investment “truth”, and why it will not survive in our sound-bite world. Still, it can’t be ignored any less than the standard slogan, and those rare investors who do read and ponder on it might as a result make better decisions.

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