Don’t Chase Returns

Chasing returns usually won't bring them to you.

A friend who was considering changing retirement funds called me recently to ask what I thought about the change. I didn’t have much to say, except that it’s probably a good idea to try to find the lowest fees possible and invest in index funds. After checking the year to date (YTD) returns for each fund, he realized that the fund that he was already in was up almost 10% more than the fund he’d been moving to. He me back and asked if he should stay with the old fund to gain the extra returns for the remainder of the year.

Of course, I don’t know the answer to that. Over the remainder of the year, his old fund might go up 1000%. I don’t know anything about it. I don’t know what it’s invested in, or how it’s gained it’s market beating returns, or whether it’s likely to continue. I can, however, spit out some famous investing maxims. These are some of the ones I hit him with: (1) past performance isn’t an accurate predictor of future success, (2) it’s easy to confuse genius with a bull market, (3) don’t chase returns, and (4) don’t focus more on the return than the risks undertaken to earn that return.

When I think of the past performance maxim, I think of growth. Companies can’t grow at 30% a year forever. This makes sense. Eventually things become as big as they can be. Once you put a Starbucks or a McDonald’s on every corner, it’s hard for those companies to grow in the same way they have in the past. They can come up with new ideas and new ways to use their capital – but eventually growth is going to slow and even decline. Companies don’t last forever.

The don’t chase returns rule is one that I’ve learned first hand in the past. When I first started investing, I looked up the Money 70, a recommended list of mutual funds made by the magazine. On that list, at the time, they told you the one year return, followed by the projected annual returns over 5 years and 10 years. The one year return for one of the funds (it was technically an index – for REITs) mentioned was 35%, their 5 year was 31% and their 10 year was 29% per year. When I saw that, I thought to myself, “What a great investment! Even if I make half of that I’ll be making out pretty well!” Of course, what I should have been thinking was, “how can this fun make 29% per year for 10 years? Those are ridiculous returns.” You know how this story goes right? The fund lost about 50% the next year. The price of the fund had been driven up to ridiculous levels because these returns were being advertised all over the place. Luckily, we ended up having very little money in this particular fund, but the credit for that goes to my wife. I believed the magazine. Of course, I’m older, wiser, and more knowledgeable now. I’ve read more, studied more, and talked to more people who know more about investing than I do.

Risk is an important consideration, too. Everyone has risk tolerance to spare when markets are doing well. Seth Klarman and Warren Buffett are known for keeping about half of the value of their entire portfolios in cash. This puts them in a position that enables them to take advantage of great opportunities (like market crashes), and insulates them from market dips. It might decrease their returns in the strongest market conditions, but they are also undertaking less risk by keeping that money on the sidelines (the big risk is inflation). Having less money in play also allows them to focus on their best ideas and not over-diversify into their ideas that aren’t as good. Don’t chase returns and thanks for reading.