You’ll probably read to the end of this paragraph, in hopes of learning whether this blog is worth your time. If you’re curious but not sure, you might skip below and peruse the subheadings and charts, looking for more clues.

Hey, no problem. I get being busy. We all need shortcuts. And we use them all the time. Here’s the point: Some shortcuts tend to be productive. Others, not so much.

If you guess I’m going to argue that investment shortcuts often fall into the “not so productive” category, you’re reading me just fine.

Ratings: Popular decision-making shortcuts 

Information overload can make it hard to separate the relevant from the irrelevant. Confronted by voluminous data, we often turn to ratings services as shortcuts to informed choices. Witness the popularity of Yelp, TripAdvisor, Consumer Reports, and Morningstar, among countless others.

In many cases, consumers’ purchase decisions can be well-informed by ratings. That’s because quality, or at least the perception of quality, often persists. Consider three examples—restaurants, colleges, and cars. Those with high ratings tend to keep them, while those held in lower regard tend to stay that way.

The persistence of restaurant ratings is apparent in the above table of Michelin-starred restaurants in New York City. Three of the four restaurants that received the top rating in 2006, three stars, retained that distinction in each year through 2015. The fourth lost the rating because it closed and relocated. Several other restaurants received one or more stars several years in a row, a rare achievement considering that just 126 stars were awarded to New York City restaurants in that span.

Additional evidence of persistence in performance, or at least in performance-based ratings, appears in:

  • Higher education. Of the top-ten U.S. colleges and universities, as rated by U.S. News & World Report in 2004, the lowest rank that any achieved over the next decade was 14th.
  • The automotive industry. The average top-ten family sedan, as rated by Consumer Reports in 2005, appeared in the magazine’s top-ten list an additional seven times over the next decade.

Investing is different

It is well-established that investors tend to invest more heavily in markets and market segments with strong past performance. For instance, Vanguard research has shown that the majority of cash flows into mutual funds awarded 4- or 5-star ratings from Morningstar.¹ However, as shown in the chart below, fund performance often falls off once Morningstar has assigned funds its top rating.

The inability of Morningstar ratings to predict future outperformance reflects the inconsistency of fund returns. Consider the actively managed U.S. equity mutual funds ranked in the top quintile of performance in their Morningstar style categories as of December 31, 2010. Five years later, only 16.2% of the funds remained in the top quintile. More than two times as many managers dropped into the bottom quintile or were liquidated or merged out of existence as remained in the top quintile.

Portfolio managers are not chefs

Thomas Keller, the only American chef to simultaneously earn three Michelin stars for two restaurants, suggests that success in the kitchen owes to a blend of “ingredients and execution.”² The former must be of high quality, of course. “Execution,” he explains, encompasses “knowledge, training, experience, skill, [and] tools.”

So why can’t fund managers deliver consistently satisfying returns? Do they tend to suffer from deficits in knowledge, training, experience, skill, or tools? Quite the opposite. I believe the historical lack of consistent, year-to-year outperformance by fund managers indicates a relatively level playing field in which most managers are similarly skilled.³ This contributes to a zero-sum game, in which the routine exchange of performance leadership from one manager to another is the rule, not the exception.

The inability of past returns to foreshadow future returns is not unique to active money managers. It also is characteristic of sub-asset classes, such as emerging markets, real estate investment trusts, and gold, as well as security factors, such as market capitalization. In each case, we believe inconsistent results owe at least in part to performance chasing by investors.

Performance chasing often sows the seeds of its own destruction. As investors pile into assets that have done well, valuations rise. At some point, elevated prices leave no room for disappointment. It’s as if Keller decided that each year his restaurants earned good reviews he would raise prices 10% to 20%. After a few years, even if meal and service quality remained incredible, satisfaction would ebb as diners considered the declining ratio of quality to cost.

A recipe for redirecting ratings- or performance-minded clients

You can counter clients’ natural tendency to be drawn to ratings or past performance as shortcuts to a sound investment portfolio. Start by illustrating how such shortcuts tend to be counterproductive. Explain the limited value of past-performance data. Acknowledge that such shortcuts are deeply ingrained—and reasonable in many aspects of life—and that a shift away from this mentality can be difficult. Then emphasize the power of controlling those things that investors can control, such as developing a financial plan, diversifying, minimizing costs, and rebalancing.

If you succeed in reframing investing in these ways—and encourage your clients to stick with well-considered plans throughout the markets’ ups and downs—they should be very well-served. You might celebrate your joint successes at a nice restaurant.

For a deeper assessment of decision-making shortcuts and the perils they pose to investors, read the white paper that inspired this blog: Reframing investor choices: Right mindset, wrong market.

¹Christopher B. Philips and Francis M. Kinniry Jr., 2010. Mutual fund ratings and future performance. Valley Forge, Pa.: The Vanguard Group.
²Source: http://www.thomaskeller.com/new-york-new-york/per-se/farmers-foragers. Retrieved June 3, 2016.
³Brian R. Wimmer, Sandeep S. Chhabra, and Daniel W. Wallick, 2013. The bumpy road to outperformance. Valley Forge, Pa.: The Vanguard Group.

Note:

  • All investing is subject to risk, including the possible loss of the money you invest.