SCOTT REED: The magic in investing comes from hard work



Magicians are great at making you believe what you see is very important, while really it is what you don’t see that makes the magic work.

Misdirection is critical to the success of most magic tricks. You look at the shells moving back and forth across the table and never see the magician palming the marble in his hand. It was never under the shell.

In my 28 years in the investment business, I have found that misdirection is one of the most prevalent ways to attract client assets. The reason is pretty simple – it works.

Even though every piece of literature published has a statement that says, “Past performance is not an indication of future performance,” past performance is exactly what most people in our business use to entice their clients.

Investors want to know what returns they are going to make on their investments. The answer, “I have no idea” would be correct, but isn’t really what they want to hear.

It is easy to find something that has done exactly what your clients want you to do and say, “Hey, past performance isn’t an indicator of future performance, but … look what this investment has done over the past five years.”

It’s not a stretch for clients to ask themselves, “Well, if it has done that over the last five years, what’s stopping them from doing it over the next five years?”

The problem is that it is extremely difficult for managers to repeat their good years again and again. They are more likely to underperform after periods of outperformance. The opposite is true as well. If a manager has underperformed during the past five years and is a good manager, he/she is more likely to outperform the next five years.

However, it is a hard sell to tell clients they should buy into a mutual fund because it has underperformed lately. That’s why so many commercials tout past performance as if it is some secret to success. Investors should be looking at many other factors to determine the appropriateness of their investments.

The real magic comes in the form of good hard work; looking at standard deviations; reviewing Sharp, Beta and Sortino Ratios; analyzing down-side captures ratios and R2 ratios. … the list goes on and on. But it is hard to explain, hard to teach and doesn’t create emotional satisfaction like past performance does.

It is much easier to go for the emotional close. Put ideas of hitting the investment home run in the head of investors and they will swing the bat. Bore them to death with statistics and they will fall asleep at the plate.

Don’t fall for the sparkle of past performance.

Don’t get caught looking in the wrong direction.

Focus your attention on the place where the real magic happens in investing: plain hard and often boring work.

SCOTT REED is CEO of investment advisory firm Hardy Reed in Tupelo. Contact him at (662) 823-4722 or sreed@hardyreed.

Click video to hear audio