The Perils of Investing Based on Past Performance of Stocks

— -- The future ain’t what it used to be. --Yogi Berra

The overwhelming majority of individual investors approach the stock market with a mentality that virtually guarantees failure: They believe that the future will always resemble the present.

Even though most investors know that what goes up must eventually come down, they irrationally persist in buying stocks that are highly priced. The amazing thing is that, even though many of these people are long-term investors, they ignore stocks’ long-term past performance. A stellar few months could be an anomaly – a temporary blip – in a stock’s long-term record. And it often is.

The odds are that a stock’s future performance is far more likely to resemble it’s long-term past than its recent past. This likelihood derives from what statisticians call regression to the mean. Thus, if a stock that’s currently soaring was previously mediocre for years, it’s more likely to be mediocre again soon than to remain a star.

Of course, probabilities are not reality but likelihoods. A stock that has long done well may be doing poorly now because of fundamental management problems, a shrinking market or superior new competition. And a stock that’s been doing far better lately might be this superior competition or may be among the first to tap into a bountiful new market. Nevertheless, the likelihood of regression to the mean should give pause to investors excited about current “hot” stocks and create caution against the irrational exuberance that compels them to buy high.

Yet that’s not the prevailing mentality. Instead, people fall victim to recency bias—believing that recent performance will necessarily continue. The financial services industry generally plays to this, putting talking heads on TV who pump up already over-priced stocks and generate endless headlines about stocks that have been doing well lately. For those who follow renowned forecasters, this cult of personality can amount to a siren call to failure.

If you ignore forecasters and take advice from people at cocktail parties, you’ll probably be no better off. By the time people are chattering about high-performing stocks, they’re already priced high and unlikely to deliver much growth. The party chatter is about the past, and has nothing to do with the future.

As a result of the widespread focus on recent performance, money flows into recently performing stocks and out of recent under-performers. This ebb and flow lowers and raises prices because stock prices are governed by demand: The more investors there are who want to sell, the more the price goes down. When the herd sells a stock to raise cash to buy recent performers, they may create under-valued stocks that professionals snap up at low prices.

This market dynamic is also true of entire categories of stocks. As these categories – small companies, large companies, emerging market stocks, growth stocks, value stocks -- go in and out of favor, their average returns rise and fall. It’s impossible to predict what categories will be up next year and by how much. However, next year’s stellar categories are seldom this year’s.

Various financial firms have created charts showing this pattern over time. Among these is the Callan Periodic Table of Investment Returns, a table showing the performance history of indices of various stock categories. This graphic depiction of indices’ rise and fall demonstrates the folly of basing investments next year on this year’s returns. (Similar tables are available showing the rise and fall over time of different asset classes, including stocks, bonds and real estate.)

From the way many invest, it seems that there’s a widespread expectation that the bull market will continue indefinitely, even though the last several years of the raging bull represent a brief period of market history and corrections, substantial downturns and bear markets are common. Many investors fail to protect themselves from this risk by diversifying their total investment portfolio to lessen loss. This failure often stems from fixating on current high performers. By selling other investments to raise cash to buy hot stocks, these investors tend to reduce their diversification and increase their risk.

This was the mentality in the 1990s that set many investors up for pain when the tech bull bubble popped in 2000, and in global financial crisis of 2008, when many stocks in many sectors plummeted. This was nothing new. Sir Issac Newton, the 17th Century physicist now regarded as one of the most influential scientists of all time, was able to calculate the paths of comets – but not the eventual fortunes of the South Sea Company. Newton sold his substantial holdings in the company and then, caught up in the swoon of rising investment, later reinvested at higher prices, only to eventually lose disastrously.

Perhaps this master of the physical universe should have done what many present-day investors should consider: rearranging some mental furniture to get away from the fixation on recent share price. Instead of using price, consider other long-term factors, including fundamental characteristics such revenues or earnings.

Take the S&P 500, for example. Instead of ranking stocks in that index according to price, try ranking them according to these other factors. Indices of stocks ranked this way are called fundamental indices or fundamentally weighted indices. Such rankings tend to be superior to those based on price because they filter out recency bias.

Another beneficial attitude adjustment involves taking some time to think about what you’re getting for your money when you buy a stock. You’re not getting yesterday’s performance, but tomorrow’s. What cash flow will you likely be getting a year down the road from buying a stock today? That’s the question people ask when buying a business – but, typically, not when buying a stock. They assume that a stock will give them yesterday’s performance, but they’re usually wrong.

By exorcizing recency bias from your decision-making process, you’ll be liberated to consider valid criteria that can help you strengthen your stock portfolio and potentially improve your returns.

Any opinions expressed here are those of the columnists and not of ABC News.

Jamie Cornehlsen and Ted Schwartz are advisors with Capstone Investment Financial Group in Colorado Springs, Colo. Cornehlsen is also president of Dunn Warren Investment Advisors in Greenwood Village, Colo. A Certified Financial Planner®, Schwartz advises individuals and endowments. He holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com. Cornehlsen, a Chartered Financial Analyst®, advises business owners and employees on retirement plans. He holds a B.A. from the University of Colorado and an M.B.A. from the William E. Simon School of Business at the University of Rochester. He can be reached at jcornehlsen@capstoneinvest.com.