Looking beyond performance
Julie Ann Marra: Hello and welcome to Vanguard’s Investment Commentary Podcast
Series. I’m Julie Ann Marra. In this month’s episode, which we’re taping on January 19,
2016, we’re taking a look at past performance and its role in investor decision-making.
Joining me is Michael DiJoseph, an investment analyst in Vanguard Investment Strategy
Group. Mike, thanks for being here.
Meet the speaker
Michael DiJoseph: Julie, thanks for having me. Excited to be here.
Julie Ann Marra: Your white paper, “Reframing investor choices: Right mindset, wrong
market,” looks at some of the mental shortcuts, or heuristics, that we use to make
everyday decisions and then examines how well some of them hold up when applied to
investing.
So let’s start with a basic question. When you talk about cognitive heuristics, what exactly
do you mean, and what are a few that you’ve studied?
Michael DiJoseph: Sure, thanks. So when we talk about cognitive heuristics, what we’re
really talking about are rules of thumb or shortcuts that help simplify the decision-making
process by, for example, substituting a simple question for something much more complex.
And so, for example, we talk about cognitive inertia, meaning that it can be easier to just do
nothing, or availability [bias], meaning that people rely most heavily on the information that
is surrounding them and most easily available.
It’s important to note that heuristics are not inherently positive or negative. So cognitive
inertia can be good for staying the course—for example, sticking to your investment plan
during stressful market events—but it could also be bad in the case of, say, rebalancing,
when it seems easier to just not rebalance when maybe you should.
And the final thing I’ll add here is that we can actually use these to modify investor
behavior through what we call behavioral interventions. So you may be familiar with things
such as auto enrollment: When someone starts a new job, their employer can have them
automatically enrolled in a 401(k) plan. It would be much easier to stay and invest in the
plan rather than have to opt in on their own. Also, things like auto escalation, meaning
you can increase an investor’s savings rate each year automatically, something that most
investors would probably be unlikely to do on their own.
Julie Ann Marra: So your research found that although some investors do use past
performance as a primary factor in their investment decisions, doing so may not be in their
best interests. Can you explain?
Michael DiJoseph: Sure. So let’s set the stage first. When we talk about past
performance, we’re really talking about asset classes, subasset classes, funds, all the way
down to individual securities. These principles kind of apply across the board.
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Michael DiJoseph
Investment Analyst
Vanguard Investment
Strategy Group
And so let me ask you a question. Think about the last big purchase you made. What was the
first thing you did?
Julie Ann Marra: Well, that would be my car. I went online and did some research.
Michael DiJoseph: Right, and it probably worked out pretty well for you, right?
Julie Ann Marra: It did.
Michael DiJoseph: Yeah, it usually does in most areas of life. So it’s seemingly logical to do
because it does work everywhere else in life. In our white paper, we looked at, for example,
Consumer Reports and their automotive rankings, or U.S. News & World Report, with their
U.S. university rankings—even the Michelin star restaurant rankings in New York City.
And what we found is that these rating systems tend to work; and they work in both the
sense that one thing that is rated high one year tends to be rated consistently high going
forward each year. And, furthermore, you tend to have a good experience if you actually use
these rating systems.
Now, I’ll add [that] performance information is everywhere, so it leads to this false assumption
that it must be more important. It’s that availability bias that we had mentioned.
In prospectuses for our mutual funds, for example, there’s always this powerful disclaimer
that past performance is not indicative of future results.
Unfortunately, it tends to be buried in small print at the bottom or at the very back of the
prospectus, but it’s highly important. And so past performance seems to be legitimized
because of things like that, because it’s everywhere.
And, also, the final point is that it’s often required from a regulatory perspective. SEC
regulations require that investment providers report their one-, five-, ten-[year], and year-todate returns. And so an investor sees that and says, “Well, if the government requires it, it
must mean something,” right?
Julie Ann Marra: Right. So these are all reasons why it makes sense, why you would think
past performance is a good basis for an investment decision; but you’re saying in reality,
it’s not.
Michael DiJoseph: That’s correct. Historically, any relationship between past and future
performance has been tenuous at best. In our white paper, we show what we call the
periodic table, which shows the ranking of different asset classes or investments from top
to bottom and then from left to right over a period of time. And it’s immediately obvious that
there’s no pattern.
So unlike the other examples, where things tend to be ranked highly one year and continue to
be highly ranked the year after, the story’s kind of the opposite on the investment side.
And so what we see is that the highest-ranked funds tend to have the lowest performance
going forward—yet they also have highest cash flow, which leads to what we would call a
behavioral gap, meaning that investors often don’t get the actual return of the funds in which
they invest, oftentimes due to the timing of cash flows.
So maybe a simple example would help. Let’s say we had fund XYZ last year that had
performance of 20% for the year, and 15 of that 20% occurred in the first six months of the
year. What we’re likely to see is that the majority of the cash flows that the fund had garnered
would probably occur in the second half of the year, meaning that the average person who
invested in the fund probably missed out on a good portion of that. And that’s what we would
call the behavioral gap.
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Julie Ann Marra: Hmm, okay, so timing is a bit of a factor. But what are some other reasons
why performance doesn’t better correlate with future returns?
Michael DiJoseph: Yeah, so it’s really the nature of the beast. Investment forecasting is an
imprecise science. So performance can be cyclical and random, and it’s often affected by
unanticipated information and, most importantly, investor psychology.
This brings to mind a quote from Sir Isaac Newton, who said that he “can calculate the
movement of the stars but not the madness of men.” I think it’s really appropriate here.
Julie Ann Marra: It is.
Michael DiJoseph: So what we say is that performance information’s not as durable for
investing as it is for a typical consumer purchase. And, furthermore, the performance itself
tends to actually make it harder for good performance going forward.
Julie Ann Marra: What do you mean by that?
Michael DiJoseph: So performance affects valuations, meaning that good performance often
leads to people, say, piling into an investment, which can drive up the price, and it drives up
valuations. So, for example, on the stock side, we’re talking about something like P/E ratios,
which tend to be the best predictor of future stock returns, albeit still not a very good one.
But as more money comes in, it drives up the price, drives up the valuations; and it means
you’re paying more money for the same investment than you otherwise would have been—
thus making it more likely to get lower returns going forward, ironically.
Julie Ann Marra: That’s a really good point. So I want to ask you about active funds. Couldn’t
performance be seen as an indication of a manager’s skill?
Michael DiJoseph: Sure. So, first of all, a caveat. Vanguard’s known as an indexing shop,
but it’s important to note that we’re also one of the largest active managers in the world,
with over a trillion dollars in actively managed assets. But it’s hard to determine, without a
really long time series, the role of skill versus luck in investing. But data does suggest that
investment managers tend to be highly skilled—so I think more of the reason why active
management doesn’t have a better track record is not that the investment managers are
unskilled, but rather that they’re all so highly skilled. There’s a literature on this topic of skill
versus luck, and one of the most prominent authors is Michael Mauboussin, who talks about
this continuum where in life, in sports, in investing, in other areas, there’s a continuum where
some activities are all luck, some activities are all skill. Most of the things fall somewhere in
the middle, right?
And so what we see is that investing is very likely one of those endeavors that falls
somewhere in the middle. And as the average level of skill becomes very narrow, and
especially as the average level of skill becomes very high, then that luck portion of
determining the outcome becomes proportionally more important.
Julie Ann Marra: You mean they’re all so skilled that there’s not a lot of disparity between
them, so luck plays a bigger role?
Michael DiJoseph: Right, so luck plays a bigger role and tends to overwhelm the outcome,
and it makes it a lot harder to consistently outperform.
Julie Ann Marra: So if we’re not going to be looking at past performance as a primary factor,
what should we be looking at when weighing investment decisions?
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Michael DiJoseph: Yeah, so first, I would say it’s important to take a step back and
understand what’s actually in our control and what’s actually important and to focus on those
things. So we would say, control what you can control. Reorient your expectations toward the
future, not toward the past. So focus on the future instead of the past.
And then we like to emphasize a series of timeless investment principles that form
Vanguard’s underlying philosophy. And these include goals, so: Understanding why you’re
investing and creating a plan to get there; balance, which will be developing a suitable asset
allocation using broadly diversified funds; minimizing costs, of course; and then exercising
discipline by staying with the plan.
Julie Ann Marra: So avoiding these types of biases and these inclinations, it’s easier to talk
about than it is to really do.
What advice would you give to advisors who are trying to help their clients avoid these types
of miscalculations?
Michael DiJoseph: Sure, so I think you hit [it on the head] in the question, and the first thing
is to understand that this stuff is really difficult—even for the pros. So it reminds me of a
quote from Daniel Kahneman, who is considered the father of modern behavioral finance,
and he always talks about how even he has trouble taking into account his own research. So
understand that it is difficult.
In our white paper, we proposed four approaches that advisors can use to help modify
investor behavior, and the first one is to educate on why the process of investment selection
based on recent past performance can be flawed. Secondly, communicate the importance
of long-term portfolio construction principles and goal setting rather than recent market
performance. [Thirdly,] promote self-awareness. So, discuss that a shift away from past
performance mentality can be difficult for many investors and advisors, and that decisions can
be swayed by the heuristics and biases that we’ve been talking about. And finally, coach your
clients through both periods of rising and falling markets when they need it most.
Julie Ann Marra: That’s good advice. So, Mike, this has been great. Do you have anything
that you’d like to add before we finish up?
Michael DiJoseph: Yeah, so I’d like to leave you and everyone listening with three things—all
things that we’ve covered already. And the first is to, again, recognize that this is an ongoing
process to develop the self-awareness and to reframe the investment decision-making
process. Secondly, control what you can control. And, finally, we would say consider working
with an advisor. This stuff is difficult, and sometimes it can help to kind of have an objective
perspective and a voice of reason to see you through the emotional times.
Julie Ann Marra: Mike, thank you so much for being here.
Michael DiJoseph: Thank you for having me.
Julie Ann Marra: And thank you for joining us for this Vanguard Investment Commentary
Podcast. Be sure to check back with us each month for more insights on the markets and
investing. And remember, you can always follow us on Twitter. Thanks for listening.
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