“The lesson here for investors: to reap the full benefits of an anomaly, you cannot chase the performance of the anomaly itself. In order to do so, you must be willing to accept the fact that there will inevitably be times when the anomaly is “not working.”
– Charlie Bilello
In last month’s article, we focused on “Being Non-Reactive” as one of the most important mindsets which is absolutely critical for anyone who wants to become a great investor. This month we focus on a similar, but slightly different quality…Great Investors Don’t Chase Performance
To become a great investor, one must be patient, as we have explored in the past. An important element to the virtue of Patience is the ability to understand that every investment strategy which is successful over a long period of time will inevitably have periods during which it is “not working”. Part of patience is the ability to avoid the temptation to “chase” a better performing investment strategy when yours is not working as you hoped, and give your strategy the time it needs to produce results.
This month we read an exceptional article on this topic, Chasing Momentum by Pension Partners which you can find here, and which we summarize below.
The Big Mo
We at Concentus believe firmly in the importance of Momentum as a factor in making investment decisions. We believe that asset prices tend to move in long term cyclical trends, and our investing discipline is built on the effort to identify and take advantage of those price trends over time. In other words, we seek to buy those securities or asset classes that have been showing superior recent price movement, and then own them for as long as their superior momentum continues.
As this article points out, this philosophy can seem a bit counter intuitive to many investors (especially Value Investors), because it actually does imply that past performance of security prices can be used as an indicator of future success. This can be a tough pill to swallow to someone who wants to “buy low and sell high”. Nevertheless, this article is a good exploration of the significant academic evidence that momentum can be a very important factor in investment markets over time.
Specifically, Bilello’s research found that, between 1980 and 2015, “Large Cap Momentum” stocks outperformed the S&P 500 by a total of roughly 2% per year. Although there were times when momentum stocks were not outperforming, they did better than the S&P 500 roughly 62% of the time. “Small Cap Momentum” stocks had an even better record over this time period, outperforming the Russell 2000 by roughly 4.6% per year, and 75% of the time.
Note: Please reference the article for an explanation of the methodology and indexes used to claim these results.
The Impact of Chasing Results
Unfortunately, like many investment strategies, momentum is not 100% consistent in its ability to deliver attractive performance results. Even though momentum stocks usuallyoutperform the general markets, they don’t always do so. In the case of Large Cap momentum stocks in the period studied, momentum outperformed the S&P 500 for 62% of the time – not a bad batting average – but this also means that 38% of the time momentum was lagging the S&P 500.
It is those 38% of the days which can be problematic for most investors. During times when your investment strategy is not performing, it is human nature to begin to doubt your strategy, become impatient with it, and become tempted to jump to another, better performing approach. When you open the Wall Street Journal or turn on CNBC, your eye begins to wander to all of those “hot funds” which are doing better than your portfolio, and you begin to think that perhaps “the grass is greener” with a different portfolio strategy. Before long, you find yourself “chasing” the performance of an alternative investment discipline.
The urge to “chase performance” is only natural, and even the best investors are tempted to fall prey to this. However, there is a fundamental problem with this: typically, just when a particular strategy has had a period of significant superior performance, is usually around the same time it will begin to lag. The opposite is also true – usually just when a given discipline has lagged for a while, it may be poised to make a great run.
To demonstrate this fact, this article took a look at what would happen to an investor’s returns using momentum strategies, if she attempted to time her investments into momentum strategies, chasing performance after years when momentum did well. He found that an investor who jumped into momentum strategies only in years after a year of superior performance saw the entire benefit of investing in the strategy disappear over time.
As Biello puts it:
Therein lies the problem for many investors when it comes to anomalies. They tend to chase performance, reducing or eliminating the benefits of the anomaly itself. The notion is particularly perplexing when it comes to momentum investing because while chasing security prices in a systematic fashion works over time, chasing the return stream from that chasing does not.
The lesson here for investors: to reap the full benefits of an anomaly, you cannot chase the performance of the anomaly itself. In order to do so, you must be willing to accept the fact that there will inevitably be times when the anomaly is “not working.”
Your ability to stick to a strategy matters more than the strategy itself.
Let me repeat the last line: Your ability to stick to a strategy matters more than the strategy itself.
Even Buffett is not Immune!
“Thou shalt not chase Performance” is an investment commandment to live by, and does not apply only to momentum strategies, but to all investing disciplines. My favorite example of this is Warren Buffett’s Berkshire Hathaway. Buffett is arguably the greatest investor of all time, if not the greatest “Value” investor. However, even Value investing strategies executed with a high level of skill are not immune to this rule.
As an example of this, consider the performance history of Buffett’s investment company, Berkshire Hathaway:
On July 1 1998, the Class B shares of Berkshire Hathaway traded for $52.06, and the S&P 500 traded at 1148. By March 1st of 2000, Berkshire stock had fallen to $29.40, down some 43.5% – but the S&P had risen to 1379, or an increase of over 20%! As hard as it may be to imagine, the world’s richest man, and greatest investor of our generation, had fallen behind the S&P 500 by over 60%!
What happened next is fairly predictable. Investors began to head for the exits, and to sell their positions in Berkshire Hathaway. Buffett became the object of significant ridicule, as an “old man”, who had no understanding of the “New Economy”. The investing public began to believe that Value investing was dead, and stodgy old codgers like Buffett had no clue about how to invest in this new world.
And value investing began to take off…
For the next 5 years, Berkshire Hathaway went on a tear, moving from $29.40 on 3/1/00 to $60.42 on 3/1/05 – an increase of just over 100%. During the same period, the S&P 500 declined from 1379 to 1210, a drop of roughly 12%.
Buffett and his Value Investing disciples had the last laugh, and once again investors learned an important lesson about the wisdom of “chasing performance”.
Having a Plan
The very best investors have a disciplined approach to making portfolio decisions, and always stick to their plan, no matter what the rest of the world is doing.
All disciplined strategies tend to work quite well over time, as long as they are followed with discipline. That is not to say that disciplined investing is “easy” or that it “always works.” Far from it. It must be executed in a systematic fashion, with consistency and without emotion. Investment returns are inherently cyclical, which means there are periods of above-market performance as well as periods of underperformance. The trick is to stay with the discipline through the entire cycle, and never “chase performance”!