Emotional Trading: Don’t Chase the Hot-Dot By: Gabriel PotterMBA, AIFA® 2015.03.13

There is no denying it, US based investors have been beating diversified investors.  Ignore the grand theoretical reasons for international investing and let's just focus on the returns.  Since the financial crisis, the relative strength of US corporations have generated strong returns for our stock market.  Furthermore, the solid moves of US monetary policy have made the dollar particularly strong over the past five years.  In fact, that strength has been high enough to mute the longer term advantages of international investing.

Nervous investors look at the relative failure of diversification and may ask the question: “why should we have international investments at all?” It’s a fair question, but there is an unsafe implication within it.  When we include the unsaid implication, the question becomes:  “why should we have international investments since we know future performance is going to look like past performance?”

This reasoning should be an immediate red-flag to everyone in the financial industry.  Nearly every financial statement, performance report, fact card, and prospectus is emblazoned with the standard industry disclosure:  past performance is not a guarantee of future results.   

Moreover, performance for securities does not occur in a vacuum of information, where yesterday’s results have no bearing on today’s results.  Rather, we could make a very sound argument the stock (or asset class, or investment strategy, etc) that outperformed today is LESS likely to outperform tomorrow.

Consider this example:  there are two companies – Freddy’s Computers and Meyer’s Computers – which are materially identical.  Their business models, financial strength, projected earnings, and growth prospects are essentially the same, but they naturally trade independently on a stock exchange.  They start trading at the same price, $100 per share, but a large shareowner of Freddy’s computers has to immediately dump a lot of shares to make a large payment.  The price of Freddy’s stock drops to $90 per share while Meyer’s Computer’s remains at $100 per share.  Which is the better deal? 

The emotional trader thinks Meyer’s computers is the better deal because its price remained stable. Meyer’s computers is the out-performer in this example.  However, the logical trader thinks Freddy’s is the better deal because he can buy an identical business – with equal dividends and growth prospects – for a cheaper price.

The core lesson is this:  it isn’t enough to look backwards and pick winners based solely on emotion.  Don’t simply base your investment decisions on what did well yesterday.  The goal is to find which combination of securities is likely to satisfy your goals tomorrow.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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