Every so often a client shares a story with me about someone who claims to be a successful investor. Often it’s the tale of a family member, friend or work colleague who has tried his hand at a strategy like picking individual stocks and is boasting about how “it worked for me.”
I’m naturally skeptical about these stories. The fact is most individuals have no idea how to properly measure how well their strategy is working. Calculating your personal rate of return is not nearly as easy as it sounds: not only do you have to look at the change in the value of the investments, but you also have to properly account for the timing of cash inflows and outflows. Most brokerage statements don’t do this for you, so as an individual you need to keep careful records and be handy with a spreadsheet.
Even if someone does the calculation properly, does he really know whether he outperformed a comparable index on a risk-adjusted basis? If not, how do we know whether his stock-picking skills added any value? You might hear someone boasting about getting a 15% return by selecting “top-quality” Canadian dividend stocks. Sounds great, but what if the Canadian market returned 20% over the same period? Or the market may have also returned 15%, but with only half the volatility of the individual’s stock portfolio. In both cases, the 15% return isn’t successful at all.
It Works—Until It Doesn’t
But let’s assume that so-and-so really has enjoyed genuine success over the last year, or three years, or even five. Is that really a reason to abandon a proven long-term strategy and follow in the friend’s footsteps? There will always be success stories in investing—just as everyone knows someone who has had a big win at a casino. The question is, what is the probability of that success? Is it higher than you would expect from random chance? And is there any way to identify winning strategies in advance? Unfortunately, no.
Believe me, if I could find an active strategy or magic bullet that I genuinely believed would outperform over long periods, I would use it. But there’s just no consistency. Strategies work until they don’t. And investors who gravitate toward what has worked in the recent past—in other words, those who chase performance—inevitably end up disappointed.
You’ve no doubt noticed that mutual fund reports include a disclaimer: “Past performance is not a guarantee of future results.” That line isn’t just there to satisfy the regulators: it’s there because it’s true. Yet investors love to talk about past performance, and many seem convinced that good results can be reliably repeated.
Sometimes Luck Looks Like Skill
Carl Richards, author of The Behavior Gap, uses an analogy I like. If you’re renovating your kitchen, he says, it makes sense to find a contractor with a glowing list of references. You have every reason to expect that if the contractor has done brilliant work in the past, they’ll build a fantastic kitchen for you, too. But that logic doesn’t hold in the financial markets. We simply don’t know whether a money manager (or amateur stock picker) enjoyed recent success because of skill or luck—and it would take decades before the data would allow us to tell the difference. By that time, you can be sure the genuinely skilled managers will be retired and living on their own private islands.
Here’s another analogy I like to use when my clients share “it worked for me” stories. If you have a headache, you can take Tylenol and be confident that it will work: for a medication to be approved for sale in Canada, it has to go through rigorous clinical trials to make sure it’s safe and effective. You could also use a homemade herbal remedy your neighbour brewed because “it worked for me.” It may or may not be effective for you, too, but even if you feel better you won’t know whether it was really the herb that cured your headache, because there’s no science behind it. Next time you have a headache you could take the same concoction and get a completely different result.
I’m not trying to be cynical, just skeptical. It’s easy to be tempted by investment anecdotes that contain no real insight and can’t be repeated. A better approach is to use a strategy that is based on a solid foundation of empirical evidence. It doesn’t make for the most entertaining stories, but it gives you the best hope of real success.