The definition of insanity applied to investing
(MoneyWatch) A popular definition of insanity is, "doing the same thing over and over and expecting different results." Despite an overwhelming body of evidence to the contrary -- and the Security and Exchange Commission's required disclaimer -- one of the strongest held beliefs among the investing public is that the past performance of active managers is a reliable predictor of future performance.
Too often, based on this strongly-held belief, investors adopt one of the following strategies: 1) They study the performance of actively managed mutual funds and buy the ones that have had the best performance recently. 2) They rely on others to perform that due diligence. For example, many investors rely on Morningstar's rating system to identify future winners. Others rely on publications such as Money, Smart Money or BusinessWeek. Still, others hire financial advisors to perform that role.
Perhaps most surprisingly, some financial advisors hire other firms (e.g., Russell Investments, SEI Investments), to help them hire the managers which are identified with the best past performance to manage their portfolios. Let's examine the process by which the typical institutional investor, such as a pension plan, chooses investment managers.
The best of the best?
Institutional investors and the consulting firms they hire, perform thorough due diligence of the historical performance of thousands of fund managers. They narrow the list by screening for not only long-term performance, but for such issues as performance in bear markets, management tenure, investment process, and the discipline to adhere to a well-designed strategy. They then hire what they consider the best of the best. To build a diversified portfolio, they might hire one manager for each of, perhaps, 10 asset classes. The story typically proceeds as follows.
At the end of each year, the institutional investor reviews the performance of their managers. Almost inevitably, they find that several have underperformed their benchmarks. They fire the underperformers and the search begins again, using exactly the same process. They rarely stop and think: "Why, if the process is the same, should we expect a different outcome? Why do we believe our due diligence will identify future winners the next time, when the same process failed to identify them the previous time?"
It seems obvious that unless you do something different, there is no logical reason to expect a different outcome. Yet, that is exactly what these pension plans do -- they expect a different (better) result.
Individuals are no different. For example, they might purchase a fund that carries Morningstar's five-star rating. Unfortunately, one study found that there's only a 50 percent chance a five-star fund will have that same rating one year later. Thus, it is apparent that before long, they will be repeating the process.
Hope triumphs over reason
Why do investors continue to follow a strategy that academic evidence has demonstrated is highly likely to lead to below benchmark performance? One explanation is they might not be aware of the evidence. Another is that it is an all-too-human trait to allow hope to triumph over reason and experience.
The lesson for investors is that unless you can clearly identify a different process, there is no logical reason to expect a different outcome. And since the institutional investors, using the very best consultants in the business, have been failing for decades, it seems unlikely that individual investors, let alone institutional investors, will find a better way to identify future winners.
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