“My neighbour had this investment, and they made over $1M!”
Sounds intriguing right? Well, it might be a little misleading, because there’s more to it than that. Let’s explore why that is.
This article looks at Chasing Returns & why it’s a bad idea.
The common approach for people to pick an investment is to look at history. The average person will look at an investment and how it’s performed over the last 1, 3, 5 or 10 years, depending on how they judge their criteria. Even a huge number of financial advisers take this simplistic and flawed approach.
Then those returns are mapped onto the future, so if a stock returned 15% per year for the last 5 years, someone will assume it will be a good investment.
The same assumption is made with indexes, sectors, and other investments.
People often believe that history will repeat itself and that informs their view of the future. We talk a little about this in our other video “The Best Performer”. The problem is, what’s happened in the past does not mean that’s what happens in the future. For example: The world record for the fastest marathon in 1920 was 2 hours, 32 minutes, and 35.8 seconds set by Hannes Kolehmainen at the 1920 Summer Olympics held in Antwerp, Belgium.
If you ran a marathon at 2 hours and 32 minutes today, you would not even be competing in the Olympics, so what worked before, doesn’t necessarily work anymore.
Let’s examine some real world examples of different investments though and see how it has worked out for the typical investor.
Cathie Wood is a big name portfolio manager of the ARK Innovation ETF (ARKK) which has returned 23.5% annually since its original launch in 2014 compared to the S&P 500’s 14.6% annualized return over the same period
Between 2019 and February 18, 2021 ARKK returned whopping 203% compared to a still respectable but much smaller 24% return for the S&P 500.
But… then, From February 18, 2021 through January 7, 2022, the ARKK lost 43% while the S&P 500 has gained 21%.
Because most investors showed up after the performance ARKK has created no value overall for its shareholders. The small number of early investors that won big are offset by the large number of performance chasers that lost big.
That’s not unusual, for example, Peter Lynch managed the Fidelity Magellan Fund from 1977 to 1990, generating about a 29% average annualized return. Yet, according to a study by Fidelity Investments, the average investor in the Magellan Fund managed to lose money over that period. Ken Heebner’s CGM Focus Fund gained 18% annually from 2000 – 2009, ranking as the top performing mutual fund tracked by Morningstar. Yet, the average investor lost 11% per year due to poor timing.
So if you can’t just look at the history to determine what a good investment is, then what do you do? The answer is simple:
Invest in low-cost funds or ETF that diversify all around the world.
There are 47 different countries that are considered developed and emerging. You could invest in each of those 47 individually, or you could pick 1 or 2 funds that bundle them all up for you. This is what I mean when I say broadly diversified around the world. You can make it easy on yourself.
Make sure to have at least a few funds in there which might include a various stock/share funds. If you are going to be making any withdrawals in the next 10 years include some domestic as well as global bonds and some cash some.
If you wanted to include alternatives you can, and this would include things like commodities, precious metals, real estate, derivatives, crypto or other asset classes you can, but it’s wise to those to be no more than 5-10% of your portfolio.
If you’re unsure how to set this up, seek help from a professional. Note, a professional does not include your friend, brother-in-law, or your neighbour that made $1M. A professional is someone that has gone through certification and qualifications and understands data.
A starting point for a better expectation about what kinds of returns to expect from the stock market are about 7.5% if you’re truly invested in shares all around the globe. If someone tells you that you should expect 12%, they probably haven’t read serious research on what markets have historically offered. They might quote the S&P returning 10% on average per year, but that’s only one country and also, it’s had many periods that extend on for 20 or 30 years as low as just about 2%-4% on average per year. Anyone can check this in the Credit Suisse Global Investment Returns Yearbook that get’s published every year: https://www.credit-suisse.com/about-us-news/en/articles/media-releases/credit-suisse-global-investment-returns-yearbook-2023-202302.html
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