I was recently at a conference when an advisor asked Ken French—Professor of Finance at Dartmouth College and Director of Investment Strategy at Dimensional Fund Advisors—a question about some investing style that “is doing well.” Without missing a beat, Ken corrected this advisor by changing the tense: “That style has done well. But that doesn’t tell us much about the future.”
This story reminds me of a quote from Wayne Gretzky, who summed up his legendary ability by saying, “I skate to where the puck is going to be, not where it has been.” The vast majority of investors, whether individual or institutional, constantly reposition their investments to where the returns have been. This can be blatant, like buying gold after it has increased in price from $250 to $1,700. Or it can be more subtle, like adding more capital to investments that have enjoyed a few good years and avoiding those that have lagged. These investors are chasing past performance—they’re skating to where the puck has been—and they’re likely to be disappointed.
Academics who study behavioral finance call this recency bias. It’s the tendency for people to assign too much importance to what has happened in the recent past rather than looking at all available information. Over the long term, returns of various equity asset classes (such as Canadian, U.S. or international stocks) have had very similar performance and should have comparable expected returns going forward. But most investors don’t take that long view: instead they expect current trends to continue indefinitely. Problem is, asset classes that enjoy several years of outsized returns will return to average eventually.
We Don’t Know Where The Puck Is Going
One of the qualities that made Wayne Gretzky the greatest hockey player of all time was his instinct for knowing where the puck was going to be, even before his teammate made a pass. Unfortunately, investment gurus don’t share that same instinct, even if they confidently boast about knowing where markets are headed.
Lately people have been asking me whether now is the right time to invest in real estate, U.S. stocks, or bonds, since these asset classes have had good relative performance recently. I explain that it’s always the right time to have these asset classes in a long-term portfolio. In other words, we should remain broadly diversified, because no one knows what the next best performing asset class will be, and in the face of that uncertainty, it makes sense to hold all of them, all the time. That’s the only way to consistently and reliably capture all the returns the markets have to offer.
For investors, the lesson from Gretzky’s famous quote is not that there is value in making forecasts about where the puck is going to be. The value is in not skating to where it has been.