Performance alone is not enough
When you talk about investment, it quickly becomes about performance, return or revenue. Focusing on these variables falls far short. Good investments are not possible with this one-dimensional view. On the one hand, it becomes a little more complex if you want to better measure and evaluate investments, but on the other hand, it can be incredibly relaxing if you don’t focus on performance.
But ever since the stock market came into being, investors have been trying to find tomorrow’s winners. And for generations people have been happy to analyze the list of winners from yesterday’s performance. We show why this is not such a sensible approach.
There are different types of games to bet on performance winners, which we will briefly introduce here.
The best countries and sectors
This type of game is not common among professionals, but it is mentioned here and there and sometimes even presented as a suitable strategy: investing in the country or industry that performed best in the previous year.
We simulated this again over the last 21 years for this article. In 2003 we invested in the 2002 winner. In 2004 we switched to the 2003 winner. This continues until our trial expires at the end of 2023, with our last investment being in the 2022 winner.
These are the results: those who invested in the best country received 6.6% per year. The strategy with the best sector returned 11.4% per year. If you had mixed strategies and invested in the best country or the best industry, depending on the return, you would have achieved a return of 6.9% per year. Performance is calculated based on US dollars. For comparison: MSCI all countries in the world reached 9 percent per year during the same period.
Two exception events
Whether it was more beneficial to invest in the previous year’s best sector during this period depends solely on two special events: In 2019, the IT sector was the best. Anyone who invested here was able to participate in the boom in technology stocks for two years during the subsequent corona pandemic. In 2021, the energy sector was again the winner. This was the industry that benefited from the rise in energy prices caused by the war in Ukraine the following year.
Very clearly: this was never predictable. Betting on the best countries or sectors can sometimes work, but it is certainly not a superior strategy. Anyone who does this also adds significantly more risk to their portfolio.
Similar indices stay similar
Some investors are also guided in choosing the ETF by which the index has performed slightly better than another comparable index. For example, the MSCI Europe index and the Stoxx Europe 600 index are very similar. We assign ETFs in both indices as first choice. But sometimes one is ahead, sometimes the other. It is therefore a fallacy to conclude that the currently highest performing index is best. The index concepts and rules are too similar to create systematic differences in performance between the two indices.
Small differences, nothing more
In the Stock World group we also reward several indices and their ETFs as 1st choice. The biggest differences arise from whether emerging markets are taken into account or whether the index uses sustainability filters. But if index ETFs that also include emerging markets (currently with a ratio of around 11%) perform worse, this does not mean that such an ETF is any less recommended. There are good reasons to add emerging markets, and there will likely be times when adding them will produce better results than focusing on developed countries.
Conclusion: If the indices have a similar spread and are constructed in a similar way, for example if they both weight their members according to free float, then there should be no systematic difference in return or risk. It’s just a coincidence that sometimes one and sometimes the other is better.
The best funds
We are often asked why we don’t put all the funds in one big table and simply rank the funds by performance – then you can see who has done well.
What many investors often don’t realize is that a fund manager can only be as good as the country in which he selects stocks or the sector in which he specializes. These are all factors determined by the fund. A fund from Germany does not suddenly transform into a fund from Turkey just because the manager predicts more growth in the country in the future. A growth fund doesn’t suddenly adopt a dividend strategy.
A list of fund winners across sectors and regions would simply show which countries, sectors and strategies are currently performing well and, with them, the funds invested in them. We showed at the beginning how these lists of winners are useful for selection.
It only makes sense to compare funds within a group of funds. That’s what we do with our score. However, we do not only take into account the return, but also the risk with which the return was achieved.
The best stocks
In the search for strategies to beat the market (in terms of return-risk relationship), so-called factors have emerged in academic literature. These are stocks with characteristics that can outperform the market in many (not all!) market phases.
One of them is the “momentum strategy”. Depending on the structure, it includes stocks that have performed best in the last six or twelve months. However, some financial scientists do not attach any importance to the momentum factor because there is no economically rational explanation for why the best stocks of recent months should continue to perform better than others in the future. On the other hand, it is conceivable that a large number of market participants are still only too happy to jump on the winning bandwagon and thus set in motion a self-fulfilling prophecy: their purchase drives up prices, which in turn attracts other buyers who raise prices, and so on. Even though the development of the momentum strategy seems tempting, it remains uncertain whether this market pattern will still be maintained in ten years’ time. However, investors can use the corresponding ETFs as a supplement.
Of course, there was a lot of testing to see what past performance you should be looking at. It is no coincidence that proponents of the momentum strategy look at performance over the past six or twelve months: other periods of performance have not provided such good results for stock selection.
Tip: More about momentum and other factors in our article ETF Factor.
The best securities (funds)
When market interest rates rise, bond prices fall. Long-term bonds fall more sharply than short-term bonds. The reverse is true if interest rates fall.
This mechanism led to bond funds falling by more than 20 percent in some cases during the ECB’s rapid interest rate hike – by 4.5 percentage points since the start of 2022. This seemed like a bad buy for interested new investors. Bond funds are finally interesting again because they now promise returns of 3 to 4 percent if nothing changes in the interest rate market. Before the recovery in interest rates, however, the funds had shown promising returns, but this was also just a reflection of the past and not a prediction for the future.
When it comes to bonds and bond funds, it’s best to look at the so-called yield to maturity or effective interest rate. This is not guaranteed for the funds, but it is the best indicator to estimate what you can expect if there are not many changes in the interest rate market.
Looking back doesn’t help much
Unfortunately, when it comes to evaluating a system, you can only look in the rearview mirror. Since past information is the only one available to us, we humans tend to attach a lot of importance to it. Anyone who is not implementing a momentum strategy – and this is a lot of work for private investors and possibly expensive fun because a lot of trading is required – does not need to pay attention to performance, at least when choosing an investment. It is simply not a good indicator of future investment success.
Conclusion: To achieve a good result it is important to use another insight: the scatter! It is the be all and end all to achieving the best possible return-risk profile. More about this in our article, among others Diversification when investing.