When Winning Doesn't Mean You're Right

Why short-term investment performance can tell investors exactly the wrong story

We naturally assume that good results are evidence of a good decision.

If one investment fund returned 43% and another returned 33%, which manager did the better job?

Seems obvious.

The manager who earned 43%.

But investing isn't always that simple.

Sometimes a manager can outperform for exactly the wrong reasons.

And that's an important lesson for anyone trying to choose an investment strategy—or evaluate the person managing their money.

A Strange Thing Happened in Small Company Stocks

Dr. Wes Crill, Senior Client Solutions Director and Vice President at Dimensional Fund Advisors, recently highlighted a fascinating example within U.S. small-company stocks.

Not all small-company stocks have the same expected returns.

Academic research has identified characteristics that help explain differences in expected returns among stocks. Among small companies, stocks with low profitability and companies experiencing high asset growth have historically produced lower returns than other small-company stocks.

In fact, according to the data Crill shared, small-cap growth stocks with low profitability have historically trailed the rest of the small-cap market by more than 8 percentage points, while high-asset-growth stocks have trailed by more than 12 percentage points.

So an investment strategy seeking higher expected returns would generally want to reduce its exposure to these companies.

Makes sense.

Then something interesting happened.

The "Wrong" Stocks Won

Over the most recent one-year period examined by Crill, those lower-expected-return stocks performed extremely well.

Suddenly, investment funds that owned more of them looked better.

Among the 10 largest small-cap funds Crill examined, the group with the greatest exposure to these stocks had about 14.8% invested in them.

The group with the least exposure had only 4.4%.

And look at the resulting returns:

43.1% versus 33.1%.

That's a 10-percentage-point difference.

If all you saw were the returns, which strategy would you choose?

Probably the 43% fund.

And you might be choosing it for exactly the wrong reason.

This Is the Problem With the Rearview Mirror

This is one of the great traps in investing.

We see a fund with an impressive one-year return and assume:

"They must be doing something right."

Maybe.

Or perhaps something that wasn't expected to work over long periods happened to work spectacularly well over a short one.

That's not unusual in markets.

Stocks don't receive a memo telling them how they're supposed to behave this year.

Higher-expected-return investments don't outperform every year.

Lower-expected-return investments don't underperform every year.

If they did, investing would be incredibly easy.

The important question, therefore, isn't simply:

"What performed best?"

A much better question is:

"Why did it perform best?"

Those are two very different questions.

This Is Why Chasing Track Records Is So Dangerous

Investors are constantly shown performance numbers.

Top-performing funds.

Five-star managers.

Best funds of the year.

Five-year track records.

Morningstar rankings.

And our natural tendency is to believe the winners must possess some special insight that the losers don't.

But a track record tells us what happened.

It doesn't necessarily tell us why it happened.

That's the distinction that matters.

A manager can follow a disciplined, academically grounded investment strategy and underperform another manager over a particular period.

That doesn't necessarily mean the strategy failed.

Likewise, a manager can take risks that aren't expected to be rewarded over time and look brilliant for a year.

That doesn't necessarily mean the strategy succeeded.

Outcome and process are not the same thing.

Think About a Coin Toss

Imagine two people flipping coins.

One has a normal coin.

The other's coin lands heads only 40% of the time.

They each flip their coins five times.

The second person happens to get four heads.

Would you conclude that his coin is better?

Of course not.

You'd recognize that a short sequence doesn't change the underlying probabilities.

Investing works similarly.

There is enormous variation in short-term market outcomes.

That's why a sound investment philosophy needs to be built around evidence and probabilities, rather than whichever investment happened to win recently.

Investing Isn't About Finding Yesterday's Winner

This gets to something I believe investors desperately need to understand.

Investing and performance chasing are not the same thing.

If we're constantly looking backward to determine what we should own going forward, we're essentially betting that yesterday's winners will continue winning.

That's speculation.

A disciplined investment strategy begins somewhere else.

It asks what decades of academic research and market evidence tell us about the sources of expected returns—and then builds a portfolio around those principles.

That doesn't guarantee we'll win every year.

In fact, we know we won't.

But we're not trying to win every year.

We're trying to put the probabilities in our favor over a lifetime of investing.

The Hard Part Is Sticking With It

There's another lesson here that I think is even more important.

Imagine watching another investment fund outperform yours by 10 percentage points.

That's uncomfortable.

It's easy to start asking:

"Why don't we own more of that?"

"Shouldn't we change something?"

"Maybe that manager knows something ours doesn't."

This is where investment discipline becomes incredibly valuable.

Changing strategies because of recent performance can mean abandoning a sound process precisely when the market is temporarily rewarding something else.

Sometimes the best investment decision is doing absolutely nothing.

Or, as I often tell clients:

Sit on your hands.

Let the portfolio do what it was designed to do.

Wisdom Takeaway

Don't confuse a good outcome with a good investment decision. Sometimes managers win for the wrong reasons—and sometimes sound investment strategies temporarily lose for the right ones.

The goal shouldn't be finding the manager who won last year.

It should be identifying an investment philosophy grounded in evidence, understanding why it should work, and having the discipline to stay with it when markets inevitably test your patience.

Want to Know What Your Portfolio Is Actually Doing?

If your investment strategy was selected because of a fund's track record, a manager's reputation, a Morningstar rating, or recent performance, there's another question worth asking:

What investment principles is your portfolio actually built upon?

That's a conversation I'd love to have with you.

At Epiphany Financial Coaching, part of our job is helping investors understand not only what they own, but why they own it.

Because once you understand the why, short-term market noise becomes a lot less powerful.

Credit: Inspired by Above the Fray commentary from Wes Crill, PhD, Senior Client Solutions Director and Vice President at Dimensional Fund Advisors.