Rear-View Mirror Investing

When you talk about investing with a financial advisor, they will often show you a track record and use a company that rates how well an investment has performed in the past.

It’s like investing by looking in the rear-view mirror. I understand the reason advisors do it, because legally they can’t talk about future returns, and all they can show is “past performance.” Of course, they always say “past performance is no guarantee of future results” and they’re right, it isn’t. But yet they continue to present the best past performers to clients and potential clients.

I’d like to challenge conventional investment wisdom and current investment tools, known as “hypotheticals.” A hypothetical is an illustration of investment performance projected into the future, as if it’s past performance was continuing on indefinitely. In my 25 years in the industry, very rarely did the best past performers turn out to be the right place to invest for the future. In fact when a mutual fund was rated the highest, 5 stars, it was usually the worst time to invest in it! Most tech stock mutual funds were rated 5 stars in 1999. So were large cap growth stock funds. At their peak, the performance looks the best. So when you’re shown an 18 per cent track record for 10 years, you think that’s what you’re buying for the future. You’re not. You can’t possibly get that return going forward.

Let me illustrate using bond funds. Remember when interest rates were at 18 per cent in 1982? For those of you too young, take my word for it! Anyway, from 1982 to 2010, interest rates have come down from 18 per cent to nearly zero percent. Bond prices go up when interest rates go down. Since rates came down so much, bond valuations looked like superstar performers. What are the chances that’s going to happen from this point forward? Zero! That’s right. There’s no way that can happen from the point we’re at! It’s like being at the top of a mountain and walking down to the bottom and asking, what are the chances you can go down the mountain when you’re already at the bottom? Zero! That’s why you can’t invest that way. You have to look at where trends are going, not where they’ve been.

One of the things I feel strongly about is teaching people how to identify future trends, because just like if you were a business owner and you were designing software, does it make sense to design it for a huge main frame computer in the past, or for a mobile hand-held device that’s coming in the future? I mean we know that logically with a business, but why do we think differently with investments?

So it’s really important to look forward, because there are economic cycles and patterns that occur in repeatable and predictable ways, not on a short-term basis but a long-term basis. It is possible to determine what those trends are and when we look at the mantra of “buy and hold”, the problem is that the major indexes that record performance show us that that hasn’t worked for 10 years. The major indexes like the Dow Jones, the S&P 500, and the Nasdaq, which serve to measure how well companies perform, have had negative returns, have lost money, over a 10 year period. So buying and holding through any time period is not necessarily the right thing to do. Rather what you want to do is buy and hold in the right sectors or the right future trends.

A lot of advisors came into the industry in 1982, when I did, and what we saw were two decades where stocks did well. We also saw interest rates in 1982 at 18 per cent, and declining for almost 30 years to zero. So the returns that were enjoyed during that time were partly enjoyed because we saw inflation coming down, and interest rates coming down, and so to think that those investments that did well in the last 30 years in that environment are going to be the same that do well in the next 30 years, is not a logical conclusion, and yet it’s the conclusion that most of the investment firms have you make.

Chances are we are headed back to an inflationary cycle eventually. Cycles usually run 20 to 30 years. While currently we’re clearly in a mixed bag, with deflation of real estate and inflation of food prices, for example, over the long-term, it makes sense that the pendulum will swing back toward inflation again. I wouldn’t be buying inflation hedges yet, but keep your eyes peeled, and when you start seeing inflationary signs, plan to invest for an inflationary future for 20 or more years.

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