“In the business world, unfortunately, the rearview mirror
is always clearer than the windshield.”
— Warren Buffett 

Can you imagine driving down the freeway at 65 mph looking only out of the rearview mirror?

You would clearly know that you had negotiated the roadway safely so far — but have no idea of what’s ahead where true dangers are.

Of course you wouldn’t. Yet that’s how many — maybe most — people choose investments, based on past performance.

And this in spite of clear SEC-mandated warnings that “past performance is no guarantee of future results.”

Keep in mind that there is much to learn from history — with many important lessons about investing can be gained through thoughtful study.

Learning about economics and financial markets over the decades can provide valuable background when investing.

The Morningstar Mirage

But that’s way different than one of the most prevalent behaviors exhibited by investors: chasing performance.

Study after study shows that people buy the stock, fund, commodity or asset class they wish they would have bought last year.

Research by Terrance Odean, a Hass School of Business professor at UC Berkeley, showed that 39% of new money flowing into mutual funds went into funds in the top 10% for prior year performance — and over half of the new money went into funds in the top 20%.

Yet Odean noted that studies conclude that good mutual fund performance isn’t generally more persistent than chance.

Millions of investors (pensions and endowments, financial advisers and individuals) trust Morningstar to help them decide where to put their money using the company’s star ratings.

Money flows into top-rated “five-star” funds expecting past stellar performance to continue.

But does it work? While a few years old, The Wall Street Journal’s 2017 in depth report, “The Morningstar Mirage,” suggested no.

The Journal examined the performance of thousands of mutual funds dating back to 2003, when Morningstar began using its star system.

The study found that funds earning high ratings attracted the vast majority of investor dollars — but that most of them failed to perform.

The study noted that of funds awarded a coveted five-star overall rating, only 12% did well enough over the next five years to earn a top rating for that period — and 10% performed so poorly that they were given a lowest possible one-star rating.

The Journal study noted that “findings were especially stark among U.S.-based domestic equity funds.

Of those that merited the five-star badge, a mere 10% earned five stars for the performance over the following three years. That means that a five-star rating for the equity funds was no more an omen of success than it was one of failure.

Morningstar responded to the report by saying “the star ratings are not predictive but are just a first-cut tool to understand the mutual fund inverse.”

Hot Funds Flame Out

Now let’s talk about chasing into “hot funds” — those with spectacular recent performance.

Remember the profit and when new companies sprang to life in the late 1990s, spent capital recklessly, never generated a profit, and went out with a bang in 2000.

According to a 2001 New York Times article, the 10 top performing funds for 1999 all more than tripled in value during the year — and money poured in.

But they got in too late. Nine of the 10 funds lost at least two-thirds of their value by October 2001 — and the 10th was down almost 50%.

One of the funds, Nicholas-Applegate Global Technology, actually produced gains of $156 million over its first 20 months. But in the next year as a much larger fund, a 70% decline produced losses of $234 million.

Another more recent example is Ark Innovation ETF (ARKK) managed by Catherine Wood, who quickly became a money show darling when the fund had an eye-popping return of 152.92% in 2020.

Lots of money flowed into the fund only to see losses of 23.38% and 66.97% in the following two years.

According to Morningstar, ARKK has had a 9.59%  annualized return since inception — but its cash flow weighted “investor return” was -25%.

That’s because investors flooded the fund with new assets late in 2021 (after the 152.92% 2020 return) and then pulled out more than $12 billion by 2022.If that’s not performance chasing, I don’t know what is.

No Pattern for Predictability

There are similar patterns when looking at asset classes and investment styles.

Some of you who’ve been around a while may recall how Japan became an economic “poster child” back in the mid-1980s — seemingly doing everything right.

That economic resurgence resulted in foreign stocks (using the MSCI-EAFE index) being the best performing asset class for four consecutive years (1985-1988).

Allocations to non-U.S. stocks slowly increased as investors became more comfortable with the idea — and returns — of foreign investing only to trail other equity asset classes in the next four consecutive years.

Or consider how growth and value styles come in and go out of favor over time. Over the past decade, growth stocks have outperformed value stocks by more than 8% per year.

Yet over much longer time periods, value stocks have consistently been the outperformer — by more than 4% annually in the United States since 1927.

Trying to predict winning asset classes and investment styles (based on market indexes) can be a humbling experience as you’ll see from the nearby chart, one of my favorites, courtesy of Russell Investments.

Do you honestly see a pattern that would allow you to accurately predict the next year’s winners and losers? I sure don’t.

But there are some interesting takeaways from the chart: 

• There is no pattern. Winning asset classes and investment styles come in and go out with regularity and little (if any predictability).

• While stocks generally beat bonds over longer time periods, there are often years when investors would be very happy to have bonds in their portfolio.

• Both stocks and bonds beat cash in most single years — and dramatically over decades. Keeping cash to meet short-term needs makes sense — but it is not a very good long-term holding.

• Commodities (precious metals, oil/gas and agricultural products) were the worst performing asset class for both 10-year periods.

• The globally diversified/balanced portfolio was a steady/consistent choice — never best or worst — and capturing a sizable percentage of “the equity premium.”

In my mind, all of this argues to stop looking in the rearview mirror, and start building a portfolio that is well-diversified across multiple asset classes and investment styles.

You can skip trying to guess which money managers will actually “beat the market” simply by getting in the market through a mix of low-cost/tax-efficient index funds.

And then take the advice of so many highly regarded investors and stick with the plan and ride out the storms of volatile markets.

Warren Buffet once said, “there seems to be some perverse human characteristic that likes to make easy things difficult.”

Try to keep it simple.