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“Insanity: doing the same thing over and over again and expecting different results.” – Albert Einstein
Why in the world do investors completely disregard facts?
Here’s a headline for you written by Amy Whyte on a recent article that appeared at ai-cio.com: “return chasing is rampant among US pensions, endowments, and insurers, the International Monetary Fund has found.”
At first glance, this doesn’t seem to be a new revelation. Unfortunately, the vast majority of investors have this nasty habit of chasing past performance rather than chasing an investment process. But pensions, endowments, and insurers are supposed to be the smart money that has an infinite time horizon when it comes to asset allocation. Yet, the IMF has found that these so-called institutional investors are no different than anyone else when it comes to “rewarding” managers and strategies which have already performed well.
What is more insane than this is the fact that the evidence is overwhelming that “if past performance is used at all for hiring and firing managers, it is the best performing managers that should be replaced with those who have performed more poorly” as proven in “the Harm of Selecting Funds that Have Recently Outperformed” (Cornell, Hsu, and Nanigan). There findings are not new, as other studies have shown unequivocally that the best strategies to invest in on a going forward basis tend to be those which have performed among the worst over the last few years. Why? Because mean reversion is real, and buying past losers is exactly the definition of buy low, sell high.
Why in the face of overwhelming evidence that the best time to buy a strategy is when it is out of favor do investors keep falling for the same momentum chasing mentality, rewarding the past rather than giving their portfolio a future with excess returns? Behavioral finance provides answers through the lens of heuristics, but the simplest answer is because investors face tremendous regret. They see some strategy which has performed extremely well, and regret not having gone all-in on that strategy with hindsight. “It’s not too late to buy in” is the mental way of trying to bring back the past and hope for the magnitude of performance to continue.
Hope, however, is not a strategy. Respecting facts can help yield a successful way of generating long-term wealth. Every strategy, and every cycle has periods of underperformance. Our Beta Rotation Index (click here) had had many periods of underperformance against the S&P 500 over the small sample of a few years, but that has actually ended up being the exact right time to consider allocating to such an approach. Investor insanity prevents that from happening in mass. Instead, investors respond by selling out of strategies in their period of underperformance, and re-allocating to those which have performed the best. Yet, factually selling out of winners and buying into losers is how to really outperform in the future. Buying into strategies which are not “working” because of the cycle they had been in completely disrespects the fact that cycles change, and that the future can look absolutely nothing like the past.
Focus less on performance, and focus less on what’s going up. Focus more on process and mean reversion. That is perhaps the sanest thing anyone can possible do.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
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