Investing

Are you confusing hindsight with insight?

The past 20 years have been a powerful reminder of a key truth when deciding which asset classes to invest in: what worked one year may not work the next ... and vice versa

This is, of course, a familiar observation. The Australian Securities and Investments Commission requires disclaimers like 'past performance is no indication of future performance' for good reason. Yet investors (large and small) often persist in believing that past performance is an accurate market predictor, because for some reason the current situation is 'a different story'.

It is likely that the large returns from international shares in 1997-1999 (due to booming US internet stocks) caused many investors to change their views on international shares and increase their willingness to take on risk. But would so many people have lost so much money if the decline in this sector (2000-2002) had been preceded by a period of more average returns? It's unlikely that 9 per cent returns in 1997, 1998 and 1999 would have attracted so much attention that investors would have dramatically over-allocated their portfolios to funds containing US technology stocks. While there will always be movements in markets that look like 'new trends', a better term might be 'random market outcomes'. It's rarely the case that these short-term vagaries are an indication that we should modify the mix of investments we hold in our portfolios.

Musical Chairs Today's humbling observation is that investors often fall on their faces when they try to be too smart. In particular, there are three dangerous behaviours: Mistaking temporary trends for 'new market directions'. Basing next year's strategy on this year's asset class 'winners'. Letting a sudden 'insight' lead to chasing performance. The chart illustrates how single asset classes take turns at holding the best-performing and worst-performing distinctions. Our calculations show that someone investing on 1 January 1986 into a balanced portfolio (i.e. exposed 70% to growth assets), would have achieved an average annual return of 11.8% p.a. by the end of 2005. This compares with 10.2% p.a. for someone switching each year into the previous year's best-performing asset class - and that's not allowing for transaction costs, which would make the difference even greater.

Ignore the crowd

In Australia in recent years, property and the sharemarket have performed strongly, outpacing broader international markets and commanding media attention. People are asking: Should I jump in? Wrong question. In any time period, the past performance of some investment or other is sure to dazzle. The success stories attract thousands of investment dollars from eager investors, pushing prices even higher. At these times, the better question is: Will this investment be consistent with my long-term goals?

If your primary interest in an investment is its recent performance, you're probably better off sitting tight. The performance of all asset classes tends to be cyclical. People who chase the best performing investments have an uncanny knack of buying in when prices have already reached high levels and then racing for the exit when prices drop.

Lessons learned

If we've learned anything in recent years, it's that it is a good idea to hold a lot of different things. You don't want to chase any one thing in particular. Following a balanced diversified strategy gives you the opportunity to be fairly compensated for taking on risk but never subject to the possibility of having the worst-performing asset class completely dominate your portfolio.

Performance numbers shown above are based on the returns of the relevant market indices.

International Bond returns prior to 1985 are unavailable, so Australian Bond returns are used. Australian Shares: S&P/ASX 300 Accum Index, ASX All Ordinaries Accum Index prior to 31 March 2000. Australian Bonds: UBS Warburg Aust Comp Bond Index, 1980-1989 Commonwealth Bank All Series All Maturities. Cash: UBS Warburg Bank Bill Index (Australian 91 Day Treasury Notes prior to 1988). International Shares: MSCI World Net Div Reinvested Accumulation Index ($A) and International Shares Hedged: MSCI World Net Div Reinvested Accumulation Index $A Hedged, MSCI World Local Currency Index prior to 1988. International Bonds: Lehmann Bros Global Aggregate Index $A Hedged. Property Securities: S&P/ASX 300 Property Accumulation Index (ASX Property Trust Accumulation Index prior to 31 March 2000).

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