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Beware Hindsight in Investing Strategies

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JLP wrote a post today about how he prefers to invest in each of the market sectors equally, instead of going the route of some total market funds and weighing them based on market capitalization. He illustrates this point by highlighting the fact that the iShares DJ Total Market Index Fund (IYY) has over 17% invested in the financial sector, which has been taken out to the woodshed as of late. See? His strategy of equal weight has prevailed!

JLP vs. iShares: JLP Wins!

I ran some more numbers, using Google Finance to extrapolate the performance of these funds over the last year (year to date, so 11 months) and then over 5 years to see if his equal weighting plan would’ve held up. The result? Investing in his allocation beats the current iShares DJ Total Market Index Fund allocation (assuming it never changed in five years and JLP’s allocation numbers were accurate) by 0.7%. The JLP Fund would’ve returned 12.7% year over year whereas the iShares DJ Total Market Index Fund returned 12.0% year over year. (If you look it up on Google Finance, the numbers don’t match up with the iShares DJ Total Market Index Fund historical figures because the allocation likely changed).

For those who love numbers, here were the ones I used:

Fund YTD Return 5 Year Return
IYM 26.4% 106.01%
IYE 25.05% 220.16%
IDU 14.33% 120.02%
IYW 13.19% 61.84%
IYJ 12.5% 85.7%
IYH 9.67% 44.02%
IYK 9.38% 59.61%
IYZ -1.35% 41.37%
IYC -4.05% 41.09%
IYF -14.89% 38.5%

What This Means

Unfortunately, like many things, not much except to provide a warning. The benefit of hindsight is that you know what already happened (duh!). In this particular case, we now know that JLP’s theory held up as long as your transaction costs didn’t eat up that 0.7% in returns (and it might very well have, depending on how much you’re investing). However, I would warn against this type of thinking, justifying your decisions after you’ve made them based on their performance.

Hindsight is dangerous because past performance is not linked to future results, everyone who reads a prospectus knows this, however not everyone believes it. Why do casinos put a roulette wheel’s history on a screen? They know that people who see a lot of red numbers are more likely to bet black. Hindsight makes sense for things that are linked, like your life decisions, but they aren’t good for random walks.

{ 6 comments, please add your thoughts now! }

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6 Responses to “Beware Hindsight in Investing Strategies”

  1. Kurt says:

    Correct. I can understand the idea behind doing your own sector weightings (trying to limit exposure to a given area) but the type of analysis that you used as a straw man, is not the reason.

  2. JLP says:

    Oops. I guess I should have run my post by you first before I published it.

  3. kurt says:

    Why do you say that? Seems like an odd thing to say.

    Just trying to help.

  4. JLP says:

    Kurt,

    Sorry. I was talking to Jim.

  5. Dang, JLP, he highlighted your post and linked to you. Why so snotty?

  6. mbhunter says:

    Traders back-test their methods all the time. It would be unwise for them not to. Any method can fall apart at any time, of course, but it’s unlikely that future events are totally uncorrelated with past events, as in the roulette example.


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