(PUB) Investing 2016

beats the market every time, year in and year out. It didn’t in 2007 (missing by 0.3%); it didn’t in 2009 (a miss of 7.0%); and to my chagrin, we missed in 2011 (by 2.6%), 2012 (by 2.8%) and 2014 (by 8.5%). Plus, Hot Hands was decidedly cold in 2008 if you didn’t take my advice (my qualitative advice) to avoid the now- defunct Growth Equity. Still, I’ll count that turkey’s 47.9% loss in the record— warts and all. All the results, by the way, can be found in a table on page 5. So let me repeat: I am not telling you this strategy is a lock on doubling or tripling the market’s return every year. And I’ve never advocated that you sink your entire stash into this year’s (or any year’s) Hot Hands fund. That would be foolish and would fly in the face of the diversified investment approach that I preach to all Vanguard investors. While I’ve often allocated a portion of my Growth Model Portfolio to the Hot Hands fund, I don’t always do so, and I certainly don’t go overboard when I do. My feeling, though, is that growth-oriented investors (particularly those who, like me, benchmark their overall performance against the stock market) can often improve their total portfolio’s performance by making sure that at least a portion of their money is following the Hot Hands strategy. Hot or Not The first question that investors new to this strategy always ask is, “Why are Hot Hands hot?” Well, not all of them are, as some recent years have shown. Full stop. But if you read on, I’ll show you that within the Vanguard family, there is strong evidence that top fund performance persists. That “repeat win- ners” can stay ahead of the masses. Or as I like to put it: Hot Hands stay hot. This cuts against the grain of fund industry dogma that past performance is neither a guarantee nor a predictor of future results. On the face of it, this sounds reasonable. But momentum, which is what this strategy is ground- ed in, has many adherents—even at Vanguard. Consider that Vanguard has often handed assets over to quantitative man-

agers who, in part, rely on past per- formance to choose stocks for their portfolios. To name a few, just look at the momentum strategies employed by Acadian Asset Management ( Global Equity ) or Vanguard’s Equity Investment Group ( Strategic Equity , Strategic SmallCap Equity , U.S. Value and various other sub-portfolios) or the managers at Growth & Income . As I’ve said, the Hot Hands approach doesn’t work each and every year, and some “persistence of performance” investors have had their heads handed to them chasing a variant of the strategy. One fund guru who used to pursue the “persistence” theory gave it up because it didn’t work within the huge sea of funds that he was tracking, then came back to it when results turned around. But after 2007, 2008 and 2009, he began to question whether the theory still held true. It failed to beat the market in 2010, and as far as I can tell, the strat- egy has been abandoned completely. Plus, I think it’s worth noting that this persistence tracker set himself up against a rather easy benchmark: The average equity fund. I consider the average fund a low hurdle that doesn’t hold a candle to the market benchmark I use. My Vanguard-focused Hot Hands is better. One of the reasons the Hot Hands system works over the long run at Vanguard and not within the greater universe of funds is that Vanguard’s fund objectives and investment policies are very well-defined. With Vanguard’s funds, there’s little room for manag- ers to change their tactics. (Though as we’ve seen time and time again, there is room for managers to fail, and to change.) The managers do what they do, and they keep doing it, no matter how the markets move around them. If they don’t, then generally Vanguard fires them. One thing Vanguard seeks when hiring outside managers is those who’ll strictly follow their investment styles and objectives. So using the prior year’s perfor- mance as a guide for selectingVanguard stock funds is not only useful, but very profitable, because investment styles

MOMENTUM FROM PAGE 1 >

From the many emails I receive and comments posted on our members- only conversation boards, I am confi- dent that many FFSA members already know what a Hot Hands fund is, and I also know a lot of you have earned very nice returns following this strategy. But because we are constantly gaining new FFSA members, and because there apparently are a few veterans who like a regular update, I think it’s important to review the Hot Hands history and strategy at least once a year. With that said, first, I’ll walk you through the methodology I use and show you the results from both back- testing and in real time. You don’t need a computer or a calculator. You don’t need a spreadsheet. Jeff and I have done all the work for you. The Hot Hands thesis is quite simple: Investors who purchase the prior year’s best diversified Vanguard stock fund and hold it for a year, and continue with that pattern year after year, will beat the stock market over time. Another way to look at this would be to understand that investment success doesn’t disappear with the turn of the calendar. That’s it. No fancy talk. No mumbo jumbo. No candlestick charts, tea leaves, patterns in the coffee grounds or astrological observations. It’s perfor- mance, plain and simple. Now, you’ve often heard me say that investors need to be cautious of something called “recency bias,” which is the tendency to believe that what- ever’s worked most recently will con- tinue to work into the future. And I still believe that wholeheartedly. But the Hot Hands methodology is a mechani- cal system with strong backtesting that doesn’t require you to make a qualita- tive judgment to follow or not follow a particular fund, manager or investment strategy. Plus, and this is important, Hot Hands is not something I would recommend you apply to your entire investment portfolio. I never have, and I never would. And please note that in my explana- tion of the methodology, I didn’t say (and never have said) that this strategy

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