subject: Should Past Performance Affect Your Willingness To Take Investment Risk? [print this page] Its a difficult task being a good investorIts a difficult task being a good investor. Youre keen to celebrate when your investments perform well, yet youre also looking for opportunities to acquire new exposure when prices are low. Unfortunately, good investment performance and low prices rarely go hand in hand. This creates an ongoing dilemma for wealth accumulators do you want your investments to go up or down in the short term?
Many investors are reluctant to invest new money in asset classes that show poor recent performance, instead preferring to increase their exposure to the better performing asset classes. This seems to be a logical thought process, but is it conducive to the achievement of your wealth accumulation plans?
We aim to challenge this thinking by testing a strategy that relies upon recent past performance to influence investment decisions.We assumed an investor had $1 million available to purchase share market risk exposure at any month during the 10 year period. We then calculated the exposure that could be purchased at each month by dividing the $1 million by the (share premium) price at that time. For example, had they invested in March 2003 when the price had fallen to $0.81, their $1 million would have purchased 1.23M units of exposure.
The number of units of share exposure that could be purchased is calculated the same way for every month, for a total of 120 months. A Final Portfolio Value for each monthly purchase is then determined by multiplying the units purchased by the share price per unit at the end of the period (i.e. 30 June 2010).
For each of the 120 months, we also determined the performance of shares for the prior 12 month period.The 30 months that corresponded with the worst Share performance for the prior 12 months had an average prior performance of -16.3%. The average buy in price for those months was $1.05 and the average market exposure purchased was 991,020 units. These units were worth $1.94M in June 2010.
At least for the period examined, the analysis suggests that buying share market exposure following recent superior market performance was likely to be an inferior strategy to buying following poorer performance i.e. the exact opposite to what many investors actually do.
Does this help us with any sort of predictive strategy? Probably not, as we will never know in advance which are the worst performing months and which are the best. However, waiting for confirmation of good performance prior to purchasing appears to be a poor strategy.
Is past performance important for investors?
You could imply from the above that past performance is of no use at all. Yet, its important to know that your investment strategy is performing according to expectations. In this sense, feedback on the relative performance of your strategy is valuable. We use a method that compares the return of the strategy to a market based portfolio with the same risk exposures. In this apples versus apples comparison you get to see how you have performed versus the market.
Good investors dont rely on picking the tops and bottoms of markets. Nor do they invest only when they can justify the purchase by reference to past performance. Over reliance of prior performance may not be good for your overall wealth outcome it may lead to a buy high, sell low strategy that can substantially affect the quality of your retirement lifestyle.
The aim of every investor should be to purchase as much market exposure as they can, consistent with their pre-determined capital allocation to risky assets. Improving your purchasing power has little to do with recent past performance.
by: John Raymond Leske
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