11 Dec Short term hindsight investing
I often hear or read that this or that investment portfolio “should have done better if it had only been invested in this sector or that type of company over the last year or two”. Usually this type of comment is based solely on the last couple of years and with the considerable benefit of hindsight. It’s not that dissimilar from saying that “I would’ve won £X if I’d bet on Liverpool to win the premiership” and because I didn’t, I’ve somehow underperformed.
If we could invest by simply looking at what has done well in the recent past, then life would be so much simpler. In fact, creating an investment portfolio in general would be much simpler because you could just invest in the securities, companies, sectors or countries that have the best recent performance. Not only is this data usually the easiest to come by, it’s also not over a very long period so doesn’t need much, if any, analysis.
Unfortunately, this approach of short term, hindsight investing isn’t the best way to build portfolios for the future, which is where our spending and intergenerational transfers will actually take place.
If we look at the past two or three years, we certainly wouldn’t want to have had too large a position in the UK, emerging market equities, global commercial property or value or even smaller company stocks. All these fared poorly on a relative (if not an absolute) basis compared to large companies in overseas developed markets. Overseas developed markets in turn lagged behind the broad US market, which in turn lagged behind growth-oriented stocks – particularly technology companies. Therefore in an extreme, but I’m afraid to say not that unheard of, scenario a short term hindsight investor would invest heavily in US growth stocks going forward.
This would be a very concentrated bet and would ignore the fact that all future growth expectations are already captured in today’s prices. These companies therefore need to perform better than these expectations for their prices to rise.
If we take a longer term approach and look at market data over a much longer period, what is evident is that each part of a sensibly diversified portfolio has its moments in the sun over time. I’m sure you are familiar with the following type of chart:
Source: Dimensional Fund Advisers
As the chart shows, even when only looking at the last 18 years, identifying the optimum asset class to hold at the start of any given year and then whether to retain or replace it at the end of that year is a difficult task.
In an extreme example, the short term hindsight investor in 2005 may have invested in emerging markets equities and global real estate and created a concentrated and high risk portfolio. Both would have provided high relative returns the following year but still been a high risk strategy. Then in 2007 and 2008 one or both would have produced significant negative returns. To want to place all your investment eggs in one basket – and in particular the one that has just performed best – doesn’t seem sensible to me. No-one knows what the 2020s will bring and diversification is a key tool in mitigating the consequences of the unknown.
We take a highly diversified approach when building our clients’ portfolios. We believe that limited exposure to the more risky parts of the markets, including companies in emerging countries, smaller companies, and value (relatively cheaper) companies provide the opportunity of delivering incremental returns a little above those of the broad markets. It can take some time for the compensation of taking more risk in these areas to manifest itself in an additional return and this isn’t guaranteed. If an extra return were guaranteed, there would be no risk entailed in picking up the return (so then it wouldn’t exist).
In an environment when cash delivers a negative return after inflation and the expected returns for both bonds and equities are reduced, these incremental returns are important. They happen to be all the things that haven’t done as well (in a relative sense) in the past few years, although they have still delivered strong absolute returns to investors. Those investors using short term hindsight would avoid them, potentially to their future detriment.
I’d suggest that you don’t look back and wish you’d owned a different portfolio, or bet on Liverpool to win two years in a row. Instead take comfort from the fact that a highly diversified and soundly structured portfolio, based on your financial plan, gives you every chance of a successful outcome in an unknown, forward looking world.
This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person. Your capital is at risk when investing. Past performance is not a reliable indicator of future results.