Every once in a while, a piece of mail crosses my desk that promises a new, surefire investment that is “guaranteed” to both outperform the market and offer less volatility than even the bluest of blue chip stocks.
My first reaction, of course, is to immediately liquidate everything I own, take out a second mortgage on my house, cash out my kids’ college fund and hand it all over to these obvious financial geniuses. But then I remember that those promises they’re making fly directly in the face of the two biggest truths I’ve learned over my 30-plus years in the business: namely, that risk and return are interconnected (in other words, you only get a higher return when you’re willing to take on greater risk); and that 90% of active money managers don’t even marginally beat the market, let alone massively outperform it.
So what’s the secret behind these too-good-to-be-true promises? Upon closer examination, they all turn out to be some form of data mining.
Data mining is when you look backwards, find a pattern you like, and then project that pattern into the future under the presumption that it will continue doing for the next 10 years whatever it did for the last decade. For example, if you were data mining the weather, you might say that since it was sunny all week, that means there’s a 100% chance it will be sunny for your golf game on Saturday.
For investors, data mining means looking back over the past few months or years, identifying which stocks or sectors performed best, and then extrapolating how much money you’ll make by assuming those same investments will perform just as well tomorrow as they did yesterday.
The flaw in this “logic” is that there’s a very big leap between showing that a given strategy worked in the past, and predicting what will work in the future. If investing really were that easy, we’d all already be billionaires.
I have a client, for example, whose parents always invested in nothing but banks and utilities – only the most solid companies with the best dividend streams. It was a can’t-miss strategy that handily delivered more income and better capital gains than the broader market index year after profitable year.
Based on this success, my client’s parents were convinced that all they had to do was follow the same approach forever, and they and their children would stay rich for the rest of their days. And if they lived in Canada, that’s exactly what would’ve happened. But unfortunately for my client, his parents happened to live in Europe.
Instead of being a can’t-miss strategy, the European bank boat hit a very big iceberg, and headed straight to the bottom of the charts. After a generation of outperformance, his parents’ bank-heavy portfolio dropped by more than 80% right when they needed it the most – taking the financial security and dreams of two generations with it.
Early on in my career, I remember the same type of data mining occurring around pharmaceutical stocks, which were remarkable performers throughout the late 1980s and 1990s. Investors who bought the big pharmaceutical stocks did far better than the broad market, while enjoying an ever-increasing flow of dividends.
This strategy worked like a charm – right up until late 2000, when a declining patent pool promised dismal earnings for the future, and pharma stocks slashed their dividends and dropped more than 60% in value virtually overnight.
The recent debacle of European and U.S. banks was a disgusting example of corporate mismanagement and poor governance in action. But both of these examples demonstrate the limits – and dangers – of attempting to extrapolate the past into the future.
Investors would do well to heed these hard-earned lessons. Beware of the siren song of promises based on the past, and adopt a healthy suspicion of any strategies that involve narrowing your portfolio down to a particular stock, sector or even country.
A diversified, global portfolio of stocks that includes thousands of names from all sectors may not make you rich overnight. But it will give you all the long-term return you need to live long and prosper.
Alan MacDonald an investment advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of “The Copperjar System, Your Blueprint for Financial Fitness” available on Amazon.
For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com.
All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates. Past performance is not indicative of future results.
Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.
