“What are the past returns?” That’s the first, and often only, question many ask before making an investment.
Why? Because we’re wired to believe that those returns are indicative of what we’ll receive in the future.
If an investment has gone up 25%, we expect another 25%.
If an investment has doubled, we expect it to double again.
If an investment has gone up 10x, we expect it to be a 10-bagger once more.
The more extreme the performance, the more emotionally charged we get and the more likely we are to start chasing past returns at the worst possible time.
History is littered with examples …
1) The Dot-Com Bubble
In the five-year period from 1995 through 1999, the Nasdaq 100 gained 817%, an annualized return of more than 55% per year.
Tech stocks were all the rage, and many new investors were buying in with the expectation of similar future gains.
What happened next?
The Nasdaq 100 fell more than 56% in the subsequent five years, an annualized return of -15% per year.
2) The Housing Bubble
In the five-year period from 2002 through 2006, home prices in Miami rose 126%, an annualized return of more than 17% per year.
The housing mania was widespread, but no market was hotter than southern Florida, with many investors buying multiple homes in the area in search of future riches.
What happened next?
U.S. home prices plummeted, and Miami prices fell harder than almost anywhere else, down more than 50% in the subsequent five years.
3) “Peak Oil”
At the end of June 2008, crude oil stood at $140 a barrel, 335% higher than it was just five years earlier.
Many came to believe in a theory (“peak oil”) that crude oil production was in the early stages of a permanent decline, and speculators rushed in to buy with reckless abandon.
What happened next?
The global recession worsened, and the price of oil quickly fell more than 70%. Five years later it was still 28% lower than its 2008 peak, and it remains well below it today.
4) Gold Mania
In the five-year period ending in August 2011, gold rose 192%, an annualized return of nearly 24% per year.
With the financial crisis, endless quantitative easing and 0% interest rates, the macro narrative couldn’t have been better. As a result, investor demand for gold soared, making the gold ETF ($GLD) the largest ETF in the world in August 2011.
What happened next?
Gold prices fell 28% over the subsequent five years and did not hit a new high again until 2020.
5) The Growth Stock Bubble
At the end of January 2021, the ARK Innovation ETF ($ARKK) was up more than 779% in the prior five years, an annualized return of 54%.
Billions were pouring into the fund each week, and it became the largest actively managed ETF in the world. Flows, of course, followed performance, as they always do. Nearly 90% of the fund’s inflows had come during the previous year (during which the fund was up 174%), with more than half of those flows coming in just the previous three months (during which the fund was up 56%).
What happened next?
We don’t have a full five-year history yet, but the fund has since declined more than 70%.
The names change in every cycle, but the underlying story remains the same: chasing past returns is a strategy fraught with peril.
In purchasing the hottest investment today, you don’t receive its coveted historical track record. Instead, you’re more likely to experience the most powerful force in markets: reversion to the mean.
The very best performing assets of the past often go on to become the worst performing, and vice versa. This is true of funds as well, where top decile performers tend to underperform the bottom decile going forward (see this study).
Many investors, of course, buy into funds after exceptional performance only to abandon those same funds after the inevitable decline. As a consequence, investor returns tend to trail fund returns by a sizable margin, known as the “behavior gap.”
How can an investor avoid the siren song of eye-popping performance?
First, by learning the countless lessons of history, a few of which I’ve chronicled here. Chasing outlier returns has cost investors dearly, adding risk to their portfolios at the worst possible time.
Second, by staying grounded and sticking to a plan. For most, that means maintaining broad diversification (across asset classes, geographies, styles and strategies), rebalancing at times to reduce risk and not letting your emotions (fear and greed) get the better of you.
Third, by using factors other than past performance (which is not predictive, as we have seen) to make investment decisions. The key question: what value does this holding add to my overall portfolio, and how will it increase the odds of achieving my goals?
The next time you’re tempted to go all in on the latest investment fad, run through this checklist. And remember, the past is gone. Don’t chase it.
