Chasing Performance Can be a Dangerous Game

As the stock market continues to gain steam (despite the recent drop on February 27) and real estate investing is becoming riskier, it will be interesting to see whether investors will learn from past mistakes or continue the typical “herd mentality” when investing in equities. The general public invests money much like 6-year-old kids play soccer – instead of spreading out and taking strategic positions on the field, everyone crowds around the ball or, in the case of the investment world, the “hot investment.”

Investing with “the best” of yesterday may make us feel warm, fuzzy and comfortable, but history shows that “top” performing investments do not typically stay on top. Standard & Poor’s latest consistency report showed that “very few” funds in 2006 were able to replicate their previous top half or top quartile performance numbers. By the end of 2006, only 13% of large, 10% of mid and 10% of small capitalization funds were able to capture a top half ranking over five consecutive 12-month periods. When looking at the top 25% of funds over the same period, only 3% of large, 2.5% of mid and no small capitalization funds maintained the top quartile ranking.

Despite these facts, note our human “herd” behavior: Stock market history shows periods of record influxes and mass exoduses of investment capital. For example, just prior to the peak values in March 2000, almost $250 billion flowed into the equity markets and 75% of those monies went into just 35 funds, according to Lipper. Those funds just happened to have Morningstar ratings on average of 4.9 (out of a possible 5). Unfortunately, those same funds lost 44% of their value on average the following year (far worse than the averages, according to an SEI study in 2002). Similarly, mass exoduses occur near the “bottom” of the market.

Even though diversification cannot ensure a profit or protect against a loss, it may behoove investors to follow this simple six-step process when looking at investment opportunities.

1. Asset Allocation: Design a customized portfolio based on personal objectives, time horizon and risk tolerance.

2. Portfolio Structure: Diversify across asset classes and market sectors to maximize returns and moderate risk.

3. Tax Management: Increase investment returns by reducing taxes.

4. Specialist Managers: Take advantage of the expertise provided by money managers who specialize in specific areas of the market. For those areas that are broad in nature, an index fund may be more appropriate.

5. Portfolio Management: Monitor your portfolio on a regular basis or utilize professionals who have systems in place that evaluate performance, style drift, and management turnover, then rebalance as necessary to maintain your proper risk tolerance.

6. Consult with a Professional Team: Review progress regularly with professionals on your team such as your CPA, attorney and financial advisor. Review how your overall portfolio impacts your estate plans, gifting strategies, cash flow, tax strategies, time horizons, risk tolerance and overall strategic positioning.