Flex your money muscles: Step 9

Eating more fish is good for your hair. Juicing two meals a day melts fat. Blueberries reduce the risk of cancer. No carbs after 4 pm. And so on and so on. Any time a new study shows a correlation between diet and fat loss, muscle gain, or any other benefit, the health industry’s marketing machine starts churning out new products to capitalize on it. Sometimes these fads can work in the short term because your motivation increases whenever you break out of your routine. But they’re not likely to be sustainable over any meaningful period. The investing world has plenty of fads, too. Remember the 1990s, when technology stocks were shooting to the moon? Simply making it known that your business plan involved the internet was enough to make your company rise in value by millions overnight. Cisco Systems famously approached a price-to-earnings ratio of 200 and was valued at about $20 million per employee. It then lost half a trillion dollars in value over the next two and a half years. A lot of people made money on the way up, then lost it all on the way down—just like the yo-yo effect you get with fad diets. Even worse, investors who follow the herd usually don’t participate in the entire run-up. They often buy in after the easy money has been made, enjoying only modest gains, then have a front row seat for the drop. They fall into the same buy-high-sell-low pattern that sinks so many investors. Compare mutual fund flows to the performance of the markets and you’ll see investors tend to chase what’s hot. It’s not until after equities have had a few years of solid growth that investors get greedy and start loading up. Conversely, the biggest flows out of equity funds and into fixed income usually occur after a stock market drop. When bonds did well over the last few years, investors piled in. When they plunged earlier this year, money flowed out. It’s easy to understand why following fads causes investors to underperform. The research firm DALBAR estimates that moving in and out at the wrong time cost equity mutual fund investors in the U.S. 4% annually over the 20 years ending in 2012. The S&P 500 returned 8.21%, while the average investor in stock funds earned just 4.25%. That “behaviour gap” is devastating to your returns. A great example of a recent investment fad is gold. Have you noticed those booths at malls across the country where you can sell your gold? That should have been the first sign of gold fever. Not long ago analysts appeared regularly on TV describing why they thought gold should approach $5,000 an ounce. Their stories were compelling: with governments printing so much currency, inflation would soon be rampant and hard assets would be the only thing holding their value. Investors clamoured for gold, only to see it lose a third of its value between April 2012 and this summer. What about yield-seeking strategies, growth stocks or small caps? The truth is, no one can reliably predict which company, strategy, or asset class will be next year’s hot performer. Investment funds are required to declare “past performance is not an indicator of future results,” and with good reason. But despite these warnings, investors seem hopelessly attracted to what has recently done well. The tried and true method of investment management is to create a plan and stick with it. Diversify across and within asset classes, rebalance periodically, and ignore the latest trends and other noise. If you can just do that, chances are you’ll be a top-quartile performer. It’s not sexy, but it works.