Buying or selling an investment based on last year’s performance
Over the years, numerous studies have shown that moving in and out of investments, funds, or partnerships based on recent performance nearly guarantees mediocre results. Perhaps the most famous of these studies was conducted by Fidelity Investments. They wanted to know how the average investor in the Magellan Fund performed while Peter Lynch was the manager.
Lynch produced a 29% annual return at Magellan, however, the average shareholder in that fund only earned 6% annually. How could that happen? Shareholders (as a group) routinely bought more Magellan shares after a good year and sold shares following the bad years.
An even more dramatic example came to light this year in Berkshire Hathaway’s annual report. For the first time, Warren Buffett published not just the change in book value for each year since 1966, but also the change in value of Berkshire’s stock. Book value is a way to measure business performance, while the stock price tells us what investors thought of that performance.
So let’s go back to 1971—in that year Berkshire Hathaway stock was up 80% vs a 14% gain for the S&P 500. If based on that spectacular year, we had bought BRK in January of 1972 the table below shows what our investment experience would have been over the next few years.
In a word, sobering. At the end of 1975, our $1,000 Berkshire investment would be worth only $554 compared with $1,025 in the S&P 500. Question: would we still own the stock after year four? Honestly, would you have wanted us to?
It took another spectacular year for Berkshire stock in 1976 just to get us back to break-even with the S&P. Even with these gains, the temptation to sell at this point would have been intense—“I finally got my money back, time to get out!”
So another question: what would we have missed in the next five years if we had sold Berkshire during this nasty and insanely volatile period outlined above? The following table shows the results.
To complete the story: Buffett’s record for the entire ten year period produced a 22.4% annual return, compared with 6% per year for the S&P 500. Practically rhymes with the Lynch/Magellan story.
Patience is a virtue in life. But even more so while investing.
Daniel A. Ogden