It's Future Performance We're After

I have this good friend and client who's a bit a more active than your everyday investor. Every now and again he'll present an idea, typically a stock, tell me what he thinks, solicit my opinion, and more often than not have me see where we can generate a little cash to take the position.

If he's not already over-weight a particular sector, I generally recommend that we take from an area I'm presently under-weighting. Upon making my recommendation, he often asks for an accounting of the past performance of the position I'd draw from. I then remind him that past performance has absolutely nothing to do with my recommendation. My choice is all about the setup for that particular position going forward, which, in my view, is less favorable than that of his other positions. As it happens -- as seasons, and trends, change -- it's not at all unusual for the position I'd exit to indeed be one of the better performers over the recent past; it's just that I now see the trend changing. 

Allow me to cherry-pick an example to make my point. Assume it's the first of July 2016 when I get the call. My friend generally asks me to choose an under-performing position to reduce or eliminate in favor of his new pick; of course that's when my lecture begins. 

Were I to take the path of least resistance -- i.e., dispense with the lecture and simply follow his instructions -- I might, in July 2016, simply reduce his exposure to financials:



Note how far below its pre-recession high the financial sector ETF was in July 2016. Plus, the recent past performance was certainly nothing to write home about.

Of course the last place -- were I to follow the path of least resistance -- I would have drawn from was consumer staples:



A no-brainer, right?

Well, let's see how financials have performed since:



And how about consumer staples?



Oops!

"Always remember", I say to my dear friend, "we're concerned with future, not past, performance"! My friend, recalling my past "always remember" admonishments, confesses to what he calls his "hardheadedness".

Here's Jack Schwager, in his indispensable book for traders, Market Wizards:

... the link between past and future performance is often a very rough one.

 Here's Alexander Elder, in his equally indispensable book for traders, Trading for a Living:

Traders love to optimize systems, making them fit past data. The trouble is, your broker won't let you trade in the past.

And, lastly, here's Mark Douglas in his analysis of the minds of traders, Trading in the Zone:

Any expectation about the market’s behavior that is specific, well-defined, or rigid—instead of being neutral and open-ended-is unrealistic and potentially damaging. I define an unrealistic expectation as one that does not correspond with the possibilities available from the market’s perspective.