A Tale of Two Clients

This week I was speaking with two people who were looking at their investments in completely different ways.

The first person had some mutual funds, and she was disappointed in their performance. She was looking to sell them and transfer her account to something else.

Now I haven’t actually sat down with her yet, so as I write this I don’t know much more than that – that she is disappointed with her performance, and she is considering selling off her accounts. There might be a very good reason for her to do this; it very well could be that we can upgrade the quality of her investments, and there is nothing wrong with that.

But let’s just say for discussion purposes that she has some good quality investments, but investments that have had some disappointing short-term, or disappointing even medium-term performance. Would that be a valid reason for selling them?

Absolutely. If a person believes in buying high and selling low, they should definitely consider selling their investments that haven’t performed well. Of course, that’s not a very good way to make money, but to each his own.

Sarcasm aside, this is all too common a phenomenon. Morningstar is a company that ranks mutual funds based on past performance. According to data from Financial Research Corp. in Boston in the first half of 2004, funds with Morningstar’s four- and five-star rankings in the United States attracted a net $143 billion USD, while lesser-rated funds suffered net withdrawals of $12 billion USD. Last year, 96 percent of net fund sales in the U.S. went to top- rated funds.

What’s wrong with that? On the surface it seems fine. Except that there is very little evidence that past performance is a reliable indicator of future performance. Quite the contrary, in fact. Today’s heroes are very often tomorrow’s goats, and vice versa.

But people love a winner, and this is where person number two enters the story. He came to me this week because he wanted to buy a stock. He knew quite a bit about the company, and the business has been doing very well. So well, in fact, that the share price has increased by 75 percent in the last year.

It’s extremely common for people to look at past performance and extrapolate the trend line into the future. In other words, this stock has gone up by 75 percent, so it’s on the move, it’s going up, let’s get a piece of the action. Of course that was also the kind of thinking that had people buying tech stocks in 1999.

Now I don’t know if this particular stock will go up or go down tomorrow, but I can tell you that companies don’t increase in value at that frothy pace forever. In fact, if the share price has already increased by 75 percent, I am going to suggest that it could be due for a little cooling off.

When I pointed this out to the second fellow he saw the wisdom in that, and asked what other companies of the same calibre are trading at prices that are not quite so heady. That’s a very smart question to ask.

So there you have it. Two investors who are looking at opposite ends of buy-high / sell-low decisions. The difference between the two is the first lady is thinking emotionally. She is disappointed with her short-term performance of her (presumably) quality investments, and wants to blow them out. The second gentleman initially was attracted to a stock that had shot up in value, but was thinking rationally, and realized that he could be setting himself up for a buy-high scenario.

I am simplifying things here to make a point. There could very well be valid reasons to selling off the underperforming mutual funds. Maybe the thing is permanently handicapped, or maybe she is not getting the advice she needs from her investment representative. There could also be reasons to buy the stock that has already appreciated rapidly. As it turns out when we look at the fundamentals of the company they are pretty solid.

It’s all too easy to get caught up in the day-to-day movements of the equity markets. Heck, some people check on their stocks several times a day. And that can lead to hasty decisions.

Let’s say that one of the reasons that you bought a house was for investment purposes. What would you do if the value of your home were published daily in the local newspaper for all to see? If property prices fell for a few months, would you be tempted to panic and sell your real estate? Probably not. So why would a person make rash decisions based on short-term market movements for their other investments?

My point is to make sure you do things for a reason. Whether its buying, selling, or just holding onto an investment, understand why. If you are considering an investment decision, but you can’t clearly define the reasons behind the decision, you are liable to end up anywhere the wind blows.

Here’s a quiz to see if you were paying attention. A good quality investment languishes for a period of time. In fact, its dropped in value since you bought it, but that’s consistent with similar investments over the same time period. Some people will be tempted to sell it, and try something new. Something, no doubt, that has impressive short-term performance, thus perpetuating the sell-low / buy-high phenomenon.

Alternatively, a different person looks at the same investment, and gets excited because he now has an opportunity to buy even more of a quality investment at a good price. He’s making rational decisions because he understands the investment, freeing himself from the emotional investing roller-coaster.

One of these people is much more likely to do well over time. Which client are you?

This article was posted in All Columns, Investment Management.
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