Many investors are lured into purchasing securities after they have had good performance in hopes that performance continues in the future. We refer to this as chasing past performance. It is a natural, yet costly investment scheme. Lately, investors have been chasing risky assets in an attempt to enhance their returns. This is because there is often a positive correlation between the risk you take and the return you receive in investing. But that relationship is not perfect, especially in the short term. There are times when taking additional risk may be wise and other times when it is not. For instance, what if the expected returns of risky assets are small? Does there come a point where the expected return is not worth the risk?
Why We Chase Returns
Investors routinely purchase securities after a security has performed well in hopes that it continues to perform well. This is because the brain, being a pattern detecting machine, detects a pattern of outperformance it believes is likely to continue. We also attribute positive investment performance to a individual’s skill rather than luck. However, if investors were truly skillful why wouldn’t they outperform all the time? Why would they choose to be skillful one year (profit) and then choose to not be skillful the next year (loss)?
The truth is that the market, especially over the short term, is random and unpredictable. But investors are still influenced to buy yesterday’s winners, even though empirical evidence demonstrates that is a very costly strategy.* Anytime you feel like selling an underperforming asset and purchasing one that is outperforming (i.e. sell international stocks and buy more US stocks), you are buying high and selling low. But chasing returns feels good in the short term.
*See Dalbar
Chasing Risk
We (individually) have no power over the performance of the stock market. When we purchase a security we are hoping it will perform well, but we are subject to what all other investors, speculators and high frequency traders do. Let’s face it, we have no control over the return, but we do have control over the risk of the portfolio. Many risky assets have done very well over the past several years; they did horribly in 2008-09. The constant is the risk or volatility of the security – it goes up and down quite a bit; the unknown is when the risk will work in our favor (positive returns) and when it will work to our detriment. Many investors today are blindly chasing risk – purchasing assets based upon good prior performance without calculating the upside and downside potential.
Risk/Reward Dynamic
In Blackjack it is recommended that if the player is dealt a 10 or 11 and the dealer is showing a 6, the player should double down. The extra risk would be wise in this scenario. It doesn’t mean the payoff is guaranteed, but it is a favorable risk/reward tradeoff. On the other hand, if the player is dealt a 16 and the dealer is showing a 10, it would be unwise to double down. It could still payoff, but the risk/reward ratio in this scenario is unfavorable. There are times when the payoff for taking risk is high, and there are times when the payoff for risk is low. What is the payoff for taking risk today?
A recent WSJ article, The New Era of Low Stock Returns, discusses expected payoffs in the stock market based upon certain metrics. Economist Robert Shiller, using his P/E valuation method and comparing it to historical performance of similar valuations levels, believes annual stock returns may average 2.5% over the next 10 years. Another method estimates stock returns at 3.5% per year. Will these estimates be accurate? I have no clue and neither do you. While the past does not guarantee what the future will be, sometimes it can act as a guide. So while you are chasing risk assets, you may want to ask yourself whether the payoff is worth it in the first place.
Expectations
Expected average returns tell us nothing about the variance of actual returns that will occur. An annual average return of 3.5% does not mean you should expect that each year, it means that is the calculated average over a period of time. The actual performance could be down 40%, followed by a recovery and eventual 3.5% annualized return. Be sure when investing that you are not focused on the average historical or expected return, rather you consider the likely variations/volatility in returns that may occur.
Risk has a positive correlation to return over the long term. But over the short-term returns are random and that correlation can be negative (such as in a bear market). You may be a long-term investor, but odds are you are influenced by short-term performance, news and emotions. When it comes to investing, it is crucial that you understand the downside potential of any investment rather than being blinded by the performance you hope for. Risk assets may provide you with greater returns over time, but the risk means that they can also lose you money…and a lot of it. Be sure the potential payoff is at least worth it.