Imagine one day as you're opening your mail and you come across a bright green envelope addressed to you with the words "Learn next month’s stock market results today – guaranteed! (Hint: it's going down)" emblazoned across the front. Of course, you toss it aside with the rest of the junk mail and soon forget all about it.
Exactly one month later you get another bright green envelope, this time with the words, “I told you so! (Next month: the market’s going higher)” in bold letters across the front. Again you dismiss the letter as just another annoying piece of junk. The next month brings the same green envelope, but with “Right again! (Next month: the market falls)" scrawled across the front. You throw away the letter, but can't help noticing that the S&P 500 does in fact fall by the end of the following month. Another month, another letter. “It's not over! (Ahead: another down month)". Now a little bit curious, you watch the market slide lower by the end of the month. The next two months bring two more letters, each time predicting gains for the following month. And right on cue the market rises each month. That makes a perfect six out of six market forecasts! The seventh bright green monthly letter arrives, but this time there's no writing on the front. You finally open the letter. Inside you read the following:
“For the last six months I've given you the benefit of my market forecasts – for free. Every month I've told you exactly what was going to happen in the stock market during the next month – and I've been right every time! Why have I given you such valuable information without charging you a single cent? Because if you're like me you've heard it all before – but seeing is believing. I wanted you to see for yourself the powerful benefits of the market forecasting model I've developed after many years of research. Hopefully you've been able to make some money using the valuable information I've already given you. If knowing in advance what's going to happen in the stock market doesn't interest you, throw this letter away and you'll never hear from me again. But if you'd like to use my forecasting system to make money every month – whether the market is going up or down – I'll send you the next 12 issues of my monthly forecast “The Profit Prophet” for less than $20 a month. Simply fill in the enclosed form and return it with your check for $239.”
Do you sign up?
If you do, you've just been scammed! Not only is the past performance you've been shown not indicative of future results, but in this case it's been used to build your confidence in a process that simply doesn't exist. The accuracy of the forecasts you've been fed for months is nothing more than a convincing illusion. But how is it possible for someone to accurately predict the market movements six months in a row without some kind of special skill or knowledge? The answer is they can't – but they can make it seem like they can. Start with 64,000 names from a mailing list of investors (mailing lists like this are readily available). Send half of them a prediction that the stock market is going up, and the other half a letter predicting the market will fall. No matter what happens in the market the following month, you'll have a list of 32,000 people who think you've been right. Do the same thing again the following month and you'll end up with a list of 16,000 people who've seen you accurately predict the market's direction for two months in a row. At the end of six months there will be 1,000 investors with first hand evidence of your amazing stock market prowess! And it's all an illusion.
Information about performance is not useless. But using performance information without understanding where it came from, or what may have contributed to it, can be dangerous. Intentional misrepresentation isn't the only thing that can lead us to misunderstand the testimony of the past. Certain favorable conditions may benefit a particular type of investment or strategy for some period of time. Investors may come to believe the performance advantages these conditions helped to create will go on indefinitely. It may seem that attractive performance is a fundamental property of the investment, rather than simply the investment’s response to favorable – and changing – conditions. Even if we understand, for example, that rising interest rates can cause bond prices to fall, 30 years of generally falling interest rates and rising bond prices may convince us that bonds are safer than they really are.
Just as illusions can seem convincingly real, real dangers can be nearly invisible. Until remarkably recently in human history, we didn’t know that bacteria and viruses existed, or understand their role in disease – but they were present, causing illness and death nevertheless. It may also be hard to fully appreciate the risk of bad things that haven’t happened yet. If we don’t notice a stop sign but make it through the intersection, was an accident really likely? If we forget to lock a door but we’re not robbed, were our possessions safe all along? Too often we can be fooled into judging the risks around us on the basis of what actually happened later – rather than by what could just as easily have happened. Ask about risk again after the damaged car has been towed back to a ransacked house.
A good year or two in the stock market can create the illusion that – whatever stocks may have done before – the risks of chasing the highest returns have largely disappeared. Not getting more of the "market’s" return can infect investors with regret when popular stock indices are soaring. Even if the performance of their own portfolio is well suited to their risk tolerance and financial goals, they may envy the return of some other investment that did better. How many investors have crashed into risks they didn’t see coming, and how many portfolios have been ransacked when investors have rushed out to chase returns and left their assets unprotected? Just since 2000 we’ve seen the Dot Com disaster and Real Estate Crisis turn investor excitement into dismay. They certainly weren’t the first investment bubbles to burst, and they probably won’t be the last.
So if past performance can be an unreliable witness, and real risks may lie hidden all around us, how should investors pursue their important financial goals?
Our advice: If you chase returns your money could end up exhausted.
What’s the alternative? We believe in using a disciplined process that:
- focuses on trying to find value
- responds to changing conditions, attempts to participate in positive environments
- and uses risk management tools developed with the goal of protecting accumulated capital from suffering devastating losses
Our experience – through good markets and bad – has convinced us that the benefits of this approach are not simply an illusion. We have seen clearly what consistently applying these investment principles has meant for our clients over the years. Flashy promises and hot markets come and go, but in our view our disciplined, risk managed approach remains the best way for us to pursue the kind of long term results we can believe in.
Gary E. Stroik is vice president, chief investment officer and lead portfolio manager, of WBI Funds. Stroik joined WBI Investments Inc. (then known as Wealth Builders) in February 1990, serving as vice president, chief investment officer and chief compliance officer. He received a B.A. in Honors English and Fine Arts from Georgetown University in 1976.