Beware Hot Picks

Posted Tuesday, June 14th, 2011 at 8:59 pm

“Assuming that last year’s winner will continue to outperform this year is like expecting a craps player in Las Vegas who has rolled five 7’s in a row to just keep rolling them. “

Investing articles may not tell the whole story

On any given Sunday you’ll likely find an article in the business section of the paper that discusses the performance of a hot stock or mutual fund or touts a new strategy for investing in a certain narrow segment of the market.

While each article has its own flavor, a common theme prevails: This investment has done well in the last 6-12 months and looks like it could continue to do well. The recommendation, whether explicitly stated or not, is often this: Get in now; don’t miss out! And it’s not just the Sunday papers that take this approach. Dozens of television commentators and thousands of bloggers ardently recommend investments day in and day out, often based only on strong recent performance.

Hindsight doesn’t count

Two big problems plague these articles. First, they rely on perfect hindsight and questionable foresight. Yes, a mutual fund that returned 40% last year stands out, but expecting a repeat performance this year is another matter. Assuming that last’s year’s winner will continue to outperform this year is like expecting a craps player in Las Vegas who has rolled five 7’s in a row to just keep rolling them.

Past performance is simply not a reliable indicator of future success. As Warren Buffett has said, “The investor of today does not profit from yesterday’s growth.”1 Spotting outperformance after the fact is simple, but predicting it in advance is more a matter of luck.

The second problem is not about what’s in the articles, but what is not. By focusing exclusively on the allure of specific stocks or mutual funds, many articles completely skip over the fundamental planning steps that should happen first. Writing an investment policy statement helps an investor define financial goals and determine one’s ability, willingness and need to take risk in the market. Without this plan in place, choosing specific stocks or funds is premature at best, like buying kitchen cabinets before having a home to furnish.

There’s no such thing as an average investor

Many people don’t need to be 100 percent invested in the stock market. A mid-career professional may only need to be invested 90, 80 or 60 percent in stocks with the remainder in bonds, while a retiree with greater need for current investment income may be better served with a portfolio that’s more heavily weighted in bonds. There’s no formula that fits all investors; every situation is completely unique. An investment policy statement brings these individual needs into focus.

Once the asset allocation is set, the equity portion of the portfolio should be diversified across different asset classes, such as large cap and small cap, foreign and domestic, and growth and value. Diversifying reduces the exposure to poor performance in any single asset class and evens out performance in a variety of market conditions.

A carefully-considered investment policy statement, prudent asset allocation and a diversified portfolio can provide valuable protection against fickle markets and the hindsight-based stock picks of Sunday columnists and know-it-all neighbors.

1http://investing-school.com/history/52-must-read-quotes-from-legendary-investor-warren-buffett/

By Timothy J Delaney, CPA, PFS of JDH Wealth Management LLC, an independent member of Bright Sky Group.

© 2011 Bright Sky Group, LLC. All rights reserved.

Bright Sky Group, LLC is not a registered investment adviser. The views expressed by Bright Sky Group represent the opinions of members of Bright Sky Group, but should not be construed as financial or investment advice. Further, the views are subject to change and are not intended as a forecast or guarantee of future results. The material provided by Bright Sky Group is for informational purposes only. Statements of future expectations, estimates or projections, and other forward looking statements are based on available information deemed reliable, but the accuracy of such information cannot be guaranteed. Statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results.
Bright Sky Group member firms are each registered investment advisers, which are independently owned and operated from each other. Bright Sky Group provides general financial information. The services, securities and financial instruments described by Bright Sky Group may not be available to or suitable for you, and not all strategies are appropriate at all times. The value and income of any of the securities or financial instruments mentioned herein can fall as well as rise, and an investor may get back less than he or she invested. Foreign-currency denominated securities and financial instruments are subject to fluctuations in exchange rates that could have a positive or adverse affect on the value, price or income of such securities and financial instruments. Independent advice should be sought for an investor’s specific needs.
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