Q. International stocks are doing really well, so I’m thinking about investing more money into them. What do you think?
Explore This IssueACEP Now: Vol 36 – No 12 – December 2017
A. I grew up playing ice hockey and continued to play in high school, college, and even now. Coaches often gave us the same advice that hockey legend Wayne Gretzky’s dad gave to him: “Skate to where the puck is going to be, not where it has been.”
Ice hockey is a fast-paced game where the participants are constantly moving, often at full speed, and the ability to read the play and get ahead of it is critical to success. In recent years, this quote has been pulled into the business world and is often used to encourage innovation, attempting to figure out what products consumers are going to want to buy in coming years. However, it can also be applied to individual investors and their portfolios.
Investors’ brains are wired such that the natural tendency is to invest money into asset classes that have done well in the recent past. Recency bias, as it is termed, is the human tendency to assume that recent trends will continue. When investors see that an investment asset class, such as international stocks or real estate, has done well recently, they assume that it will continue to do so. They not only keep their money invested in those classes, they also double down on the bet by investing more. They may even sell other assets that haven’t done as well to pile more money into that asset. Investors are truly skating to where the puck has already been.
The problem with this approach is that the various asset classes tend to go through cycles, and when an asset class has performed well, it may be more likely to do poorly than well in the near future. This comes down to valuations. This may be most easily understood by looking at a bond (ie, a loan to a company or government). As the value of the bond goes up, its yield—or how much you get paid per dollar of value—goes down and vice versa. Stocks and real estate properties work the same way: The less you pay for the asset, the higher your profits per dollar invested.
Performance Chasing Can Leave You Behind
The tendency to skate to where the puck has been in investing is called performance chasing, and it can be hazardous to your wealth. It is difficult to avoid because it is so natural to do. In addition, the financial media encourages this behavior by highlighting investments (and their purchasers) that have recently done well. This can be seen in newspapers like The Wall Street Journal, magazines such as Forbes and Money, and television stations such as CNBC. Even radio show gurus get in on the act, encouraging you to pick mutual funds primarily based on their past performance. Well, there’s a reason that mutual funds are legally required to tell you that past performance doesn’t indicate future performance—because it’s true!