Chasing returns can harm your financial health

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The tendency for analysts and investors to chase return trends is a well-documented phenomenon.

Numerous studies have showed that flows into and out of funds and asset classes are related to recent returns. Because investment returns tend to revert to a long-term average over time, however, return-chasing is a dangerous game. The greatest inflow into a given fund or asset class typically occurs immediately after it has generated above-average performance and immediately before it starts to underperform.

The following chart from Vanguard shows that at the end of 1999, the US stock market had returned over 20% for five consecutive years—the first five-year streak of its kind, ever. At the same time, bonds were in one of their worst bear markets. Investors responded by dumping bonds and buying stocks.

In 1999 and 2000, US equity funds captured 99% and 123% of fund cash flows, respectively. (A figure of more than 100% implies that investors were even selling bonds to buy stocks). As it often does, performance-chasing led investors to buy high and sell low at exactly the wrong time. From 2000 through September 2002, bonds outperformed stocks by a cumulative margin of over 70%.

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Today we find ourselves in a similar position. US equities have had a five-year streak of positive returns. US stocks have risen over 175% since the depths of the financial crisis.

Meanwhile, over the past 12 months, Australian Self Managed Super Funds (SMSFs) increased their exposure to global stocks by 37%. Most of the inflows into global stocks came out of cash, which only returned 3% last year.

Can the US stock market continue higher? Of course.

But is it a smart wealth preservation strategy to be aggressively buying overseas stocks on the back of the last few years’ performance? History would suggest, probably not.

Our belief is that asset class returns revert to long-term averages. When we rebalance client portfolios we will always be looking to trim short-term winners and add to underperforming asset classes. An analysis performed by David Swensen, Chief Investment Officer at Yale University, found rebalanced portfolios earned an average of 0.4% more per year, with less risk, over 10 years, than portfolios that were not rebalanced. While rebalancing will always reduce risk over time, it will not always increase returns.

Stockspot Model Portfolios

The Stockspot Model Portfolios continue to perform according to their risk profiles. As markets have rallied, the higher growth (Topaz) portfolio has gained 14.8% including dividends this financial year. Meanwhile the more conservative (Amethyst) portfolio with its higher allocation to bonds has returned 8.2%.

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Within the Stockspot Model Portfolios, Global and Australian shares have been the best performing asset classes with 8 month returns of 17.9% and 20.2% respectively. Bonds and emerging market shares have lagged with returns of 2.9% and 5.9%.

Gold sits in the middle of the pack with a gain of 9.5%.

All of the gains in Gold have come in the last 2 months with the metal rising from AU$1,350 to AU$1,480 over that period. It is worth noting that almost all of the large investment banks and broking houses downgraded their price targets for Gold last December. Merrill Lynch, CIBC, Citi, Goldman Sachs, Standard Chartered and UBS all lowered their 2014 forecasts to between US$1,000 and US$1,300. It would appear that many of these dire predictions were simply an extrapolation of last years poor performance when gold fell over 25%.

Brokers, financial advisers and fund managers will have you believe that they possess exceptional skills to help you buy low and sell high at precisely the right moments for exceptional returns. In reality, opportunities to time the market that are clear in retrospect are rarely visible in advance. Empirical evidence has repeatedly shown that your chance of success is remote. In fact, market-timing strategies can have a potentially devastating impact on your long-run portfolio performance.
 

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Chris Brycki

Stockspot Founder and CEO

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