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The Dumbest Investment Mistake That Everyone Always Makes
What is the single stupidest question that everyone in finance asks?
Show me your track record.
A track record is just about the worst way to make a investment assessment ever devised, yet everyone from the most sophisticated pension funds to the dumbest of retail traders thinks that that is the key to investment success.
That’s because all of us are subject to recency bias. We all assume that if you did well in the immediate past you are bound to do well in the future. Of course nothing can be further from the truth. Let me just throw a few names out for consideration. Paul Tudor Jones and David Einhorn.
Both of these guys are titans of the hedge fund world and if there was a Hall of Fame of investing they surely would make the cut. But if you were dumb enough to give them money over the past few years you would see nothing but losses.
This is far more common than you think. Take a look at mutual fund rankings and you will see that those in top quintile one year are very often in the bottom quintile the following year. In fact one the best ways to invest is to simply buy the worst performing managers and short the best performing managers on a portfolio basis. In short always bet against the jockey because horses and the terrain change. Alas the losing managers get fired and you can short most hedge funds or mutual funds -- so that is only a theoretical but not a practical investment strategy.
A much better way to analyse a trading manager is to look at his investment process. If the guys say “I never use stop losses” -- that’s pretty much a telltale sign to run as fast as you can away from the product, even if his returns show 10 years of uninterrupted gains. Nassim Taleb has the perfect analogy for this method. He tell the reader to imagine being a turkey. Every day rain or shine, the turkey gets fed. His “equity curve” is a perfect 45 degree ascending line showing no drawdowns whatsoever. Then on the day before Thanksgiving he gets his head chopped off and the equity curve goes straight to zero.
Ever since I read that passage I’ve been keenly aware of not falling for any strategy that makes me a turkey. That’s why looking at equity curves is so dangerous. You are seduced by all those profits -- but think about it for a second. What does it matter that the manager made all that money -- you will never see a penny of it. Since you didn’t trade with him then. You THINK you are getting all this reward because you are looking at the past performance but what you are actually doing is ASSUMING ALL THE RISK if you don’t understand the manager’s process.
That’s why the dumbest way to invest is by looking at a track record. Yet we all continue to make that mistake.