StockWatch

The First Shall Be Last

By Mark Hulbert,
Editor of the Hulbert Financial Digest, a service of MarketWatch.com

Of course not.

And, this approach applied to picking your advisers in the investment arena is not a good idea either. Yet, many investors right now are choosing their advisers for 2012 on the basis of how those advisers did in 2011.

To get an idea of just how bad an idea that is, consider the strategy among the more-than-600 tracked by the Hulbert Financial Digest that would have been picked a year ago using this approach. That would have been the "Rare Earth Stocks" portfolio of the Dines Letter, with a 2010 return of 139.2 percent.

In true "the first shall be last" fashion, this portfolio in 2011 lost 54.4 percent -- putting it in the bottom one percent of all portfolios monitored by the Hulbert Financial Digest.

By the way, don't make the mistake of concluding that this portfolio is still well ahead of the game, even after taking last year's loss into account. On an annualized basis, a 139.2 percent gain followed by a 54.4 percent loss works out to just 4.4 percent.

Furthermore, this portfolio's reversal of fortunes is not a fluke. Consider a hypothetical model portfolio that each year followed the model that had the best return in the previous calendar year, according to the Hulbert Financial Digest. For more than 21 years through this past December 31, this portfolio produced a 23 percent annualized loss.

For all intents and purposes, of course, that's a complete and total wipeout.

Don't conclude from this that you should, instead, follow the previous year's worst performers. By doing that, you would perform even worse.

Consider a hypothetical portfolio that, instead of following the investment letter portfolio with the best returns in the previous calendar year, you mimicked the portfolio that was the absolute worst performer. Believe it or not, this portfolio produced an annualized loss in excess of 50 percent.
What accounts for these results? Risk.

The portfolios that are at the top and bottom of the one-year rankings are almost always ones that have incurred extraordinary risk. Once in a long while, though, lightning will strike twice -- the far more certain bet is that extremely risky strategies will eventually lose big.

Incredibly risky bets are never a good idea for anything except your play money, and the portfolios at the top of the one-year rankings invariably will be very risky. So, take those rankings with little more than a grain of salt.

The rankings to pay more attention to are those that cover a lot more time than just one year. How long? I used to think that five years was long enough to separate out those with genuine ability, but I have since concluded that it has to be far longer than that. I now recommend focusing on performance covering a period of at least 15 years.

I admit that it can be excruciating having to wait that long to see if an adviser currently playing a hot hand is truly worth following. And, it's always possible that he is the real McCoy, and you miss out on some good years by waiting.

But, it is far more likely that, in the course of waiting, you discover that hot hands can turn cold awfully quickly.