Berkshire Hathaway and The Pitfalls of Performance Chasing By Eric Crittenden
Berkshire Hathaway has been one of the most lucrative investments of the last 40 years.
But during the tech bubble of the late 1990s, Warren Buffet’s investment strategy underperformed the market by as much as 60 percent. Many began to question whether the Oracle of Omaha had lost his way in the “new economy.”
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By maintaining a disciplined approach, Buffet allowed the market’s irrational exuberance to outpace him in the short run. But he knew he had a winning strategy for the long run.
There’s a hard lesson to learn here: even the best investments will endure extended periods where their strategies simply don’t perform.
When investors try to outthink and overtrade the market, they often do more harm than good. Studies show that investors who jump from one fund to the next based on recent performance tend to leave a lot of money on the table.
A study by Dalbar, a financial research firm, showed just how high those costs can be. The study compared the annual returns that average mutual fund investors achieved with active “decision making,” with what they could have achieved over the same time period with a simple buy-and-hold index strategy that tracks the S&P 500. These investors lost a potential 7.2% return – a high cost that investments experts refer to as the irrationality premium.
Performance chasing is the primary culprit. Historically, investors tend to purchase mutual funds with the best recent performance and sell out of the ones with poor recent performance.
The bad news is that humans are hardwired to choose the best recent performance. The good news is that we’re capable of exercising discipline and implementing basic rules that can short-circuit this potential irrational tendency, like many of the best investors do.
For the average person, the rules could be as simple as maintaining an asset allocation mix, or even just buying and holding a market index, as the Dalbar study shows. Whatever strategy you chose, the key is to find something that works and follow it through the inevitable ups and downs.
Not only will this most likely improve your odds of investment success, but the path travelled is likely to be less stressful as well.
Eric Crittenden is Chief Investment Officer of Longboard Asset Management, LLC, an alternative investments firm specializing in long-term trend following.