Tuesday, August 30, 2011

Past Performance is No Guarantee of Future Results

Writing to shareholders in early 2000, Warren Buffett reported that the book value of Berkshire Hathaway had grown by just 0.5% in 1999 compared to a +21.0% gain for the S&P 500.

The reason was simple: in 1999, technology stocks dominated market returns. One of Buffett's investment disciplines is that he will not invest in companies that he does not readily understand, which is why he had largely avoided technology.

Buffett took full responsibility for the underperformance, which represented the worst relative performance since he began reporting to shareholders in 1965. Still, he kept his sense of humor:

Even Inspector Clouseau could find last year’s guilty party: your Chairman. My performance reminds me of the quarterback whose report card showed four Fs and a D but who nonetheless had an understanding coach. “Son,”he drawled, “I think you’re spending too much time on that one subject.”

Buffett could joke about the subject since he knew, as all investors do, that there will be periods of time when a particular investment style will fall out of favor with overall market sentiment.

However, over longer periods of time, a thoughtful and consistent approach to investing will nearly always yield satisfactory results, as Buffett's record obviously indicates.

This morning's Financial Times carried a long article discussing the poor relative performance of many prominent investors this year. It also notes that it is not unusual for managers to suffer through periods of time when their investment acumen seems to have deserted them (I have added the emphasis):

"The best managers have clear and consistent investment philosophies to which they adhere fairly strictly, even when this philosophy leads them to investments that are out of favor in the market," says David Shukis of Cambridge Associates, a US investment consultancy. Cambridge calculates that, of the investors it tracks who feature in the top quarter by performance over the past decade, about half have spent at least three years in the fourth quartile.


Please re-read the last sentence of the excerpt from the FT.

Cambridge is saying that some of the best investors it tracks - the ones ranked near the top for the last 10 years - spent at least 30% of the last decade in the bottom ranks of investment manager rankings.

This illustrates to me the fallacy of choosing managers strictly on the basis of past performance. And yet in nearly every manager search that I have been involved in, past performance plays a crucial role in the hiring and firing decision.

Even though the mutual fund industry constantly reminds us that "past performance is no guarantee of future results", investor still too often make their decisions looking squarely in the rear view mirror.