A recent Bloomberg News headline, “Classic Cars, Lean Hogs and Duchamp Art Lead Alternative Investment Ranking,” piqued the interest of two readers who separately emailed to ask how they could get into the reported “lean hog” bonanza.
With a one year return of 56 percent on these hog futures contracts, this sounds like a great investment because it beats virtually everything else publicly available, including the highest performing hedge fund. But alas, the boilerplate warning that “past performance is no guarantee of future returns” is true in spades for the hog market. I warned these readers to stick to safer investments.
As regular news readers will know, the spectacular run-up in hog prices stems from an epidemic of a virus that kills a large fraction of baby pigs. Minnesota is only one state that is hard hit. An epidemic like this is a classic “supply shifter” that dramatically increases the price of hogs to producers and of pork to consumers.
The epidemic is far from over, and veterinary researchers are still struggling to find effective control measures. So shouldn’t prices continue to rise in this supply-challenged environment? Why not get in on the gravy train?
The answers are that markets are quite “efficient,” in that current prices, both for hogs and for futures contracts for these animals, largely reflect all available information about relevant factors like supply. This includes expectations for the future. So today’s prices already are determined by good estimates of how long and how severely the virus will continue to hurt production.
These estimates may not prove exactly true over time, and some people who bet now that things will get worse may, in fact, make money. But there is also a chance that they will take a financial bath and that other futures traders who bet on falling prices will come out on top. And prices may simply drift sideways near current levels. No one knows for sure. Most importantly, given the level of information available, no one will consistently be able to out-perform the general hog market.
Relying on past performance remains a trap for many people, however, despite the ubiquitous warning. Investment analysis firms such as Morningstar, and newsletters, tabulate the best and worst performing mutual funds every quarter and year. The Bloomberg article included a teaser for an extensive analysis due out in Bloomberg Markets magazine for September.
If the XYZ fund outdid every other fund and every other investment or speculation alternative available to households last year, why not get in on a good thing? The answer is that top performers in one year tend to be dogs in subsequent ones.
This can be true for a couple of reasons. First, the high performing funds often are small ones that were lucky in taking a stake in some specific product or sector that happened to experience the sort of “exogenous shock” that shifted supply or demand that particular year. But when publicity about this high performance motivates many in the general public to invest in this fund, its managers are faced with a larger pile of cash than they can handle. This would be true even if they had some special insight in identifying another sector that was due to boom. So they cannot replicate their success and investors are disappointed.
Moreover, since their initial success was due in part to chance, the managers of the top rated funds in one year have no guarantee of finding similarly lucrative opportunities the next, regardless of whether they are swamped with new cash. Their firm’s sales managers will tout immediate past success, but the familiar phenomenon of “reversion to the mean” is likely to set in.
Yes, some managers may be good at spotting key companies in a new technology sector. Some brokers and fund managers were better than others in identifying medical technology companies 30 to 50 years ago that proved to be real money makers for those who got in on the ground floor. But the good fortune of early investors is not guaranteed for subsequent cohorts.
Moreover, for every investor who gets in on the ground floor of a Medtronic or Facebook, there are others who buy into fledgling firms that quietly go bust. We all hear of the successes, and we may envy them, but people don’t tend to crow about the $1,000 they lost in some spectacular failure 40 years ago.
Shakespeare was right that “hope springs eternal in the human breast.” People are cheered by the dream that their fortune might improve dramatically if they would only get into some dramatically profitable investment. This is not much different than fantasizing about how you would spend a lottery jackpot. Indeed, such irrational dreams of wealth are what drive the gambling industry. But only a small minority ever hit it big, either in the lottery or in buying financial securities. It is best to plan on making about what markets return on average over the long run.
Yes, some money managers seem to beat the odds. Peter Lynch and Warren Buffett became famous from years of success, although Buffett is not doing great right now. Academics argue about whether such investing stars owe their success primarily to their skill, or if these are only the random successes that fate chose to offset many failures.
It is good to save money and to plow it into a diversified batch of prudent investments that match your willingness to take risk. Leave it there and don’t be tempted into churning by tales of spectacular success that were purely the result of unforeseeable chance.