1) Steve is the author's friend who buys investments after they have risen and sells them after they have dropped, acting as an indicator that those investments are a bad idea. 2) Many investors make poor decisions by chasing recent winners and abandoning investments as soon as they fall, hoping winners will continue winning when past performance does not predict future returns. 3) Even professionals like mutual fund managers fall prey to emotional reactions, buying high and selling low, which causes their funds to underperform simple index investing over time.

1. Your own worst investing mistakes
My friend Steve is one of the best investment barometers I know. He's smart, confident, and
always on top of the latest investment news. If something's hot, Steve is buying. And if
something's not, Steve is dumping.
In 2005, Steve bought into the supremely hot U.S. real estate market. In 2007, he joined my
investment club after we gained 17% for the calendar year. In 2011, he was buying gold.
He sold his American condo in 2009 when it lost value; he relinquished his investment club
membership in 2008 when our portfolio got hammered; and now he's thinking about selling
his gold at a loss.
In each case, he bought what was rising after it rose, and sold what fell, after it dropped.
That's why Steve's my investment barometer. If he's buying something, it probably isn't a
good idea to follow suit. He buys recent winners, and it costs him plenty.
Steve's behaviour is pretty common. Too many investors, unfortunately, look backward.
They feel comfortable putting their money on yesterday's front-runners, hoping (even
expecting) they'll continue their frantic pace. But most of the time, choosing investments
based on how they've done in the recent past is a recipe for mediocrity—or worse.
We're often attracted to hot currencies, sizzling commodities, mutual fund scorchers or sky-
rocketing stocks. Neurosurgeon and investment author William Bernstein suggests that the
part of our brains called the amygdala comforts us when we're buying yesterday's winners.
We like looking for established patterns because they served our ancestors well. As
Bernstein explains, "A hundred thousand years ago, if seeing a flash of yellow and black
stripes in your peripheral vision was followed by the gruesome death of one of your
companions, you do well to associate those two events." But finance is statistically far less
predictable than the behaviour of hungry tigers.
John Bogle, the founder of the Vanguard Group, explains this weakness in action when
examining investors' mutual fund returns. The average U.S. mutual fund from 1980 to 2005
gained 10% per year. But the average investor in those funds made only 7.3%—giving up
more than one third of their potential earnings each year. Those mischievous amygdalae
convinced people to add more money to funds that were winning, while selling (or not
adding fresh money to) the funds that weren't performing. They tried creating patterns
where they didn't exist, expecting a winning fund to keep winning and a losing fund to keep
losing. Fear of low prices prevented investors from buying when their funds were low, and
elation at high prices encouraged people to chase funds when the prices were higher.

2. Most of us, unfortunately, respond similarly to market stimuli. We react first and rationalize
later. Even investment professionals can slip on their own bars of soap. Examining the
flagship Canadian balanced funds from the Big Five banks paints an interesting picture. Most
of them hold roughly 40% Canadian bonds and 60% Canadian stocks. During the past
decade, stocks mostly surged (2003—2007), interrupted by the occasional dramatic collapse
(2002, 2008). Did the fund managers fall into the psychological trap of chasing stocks when
they soared, and abandoning them to chase bonds when stocks fell? I think they did.
During the 10 years from December 2001 to December 2011, the balanced funds from
Canada's big banks (TD Balanced Growth; CIBC Balanced; BMO/ NB Balanced; Scotia
Canadian Balanced; and RBC Balanced Fund) were each whipped by an equally weighted
portfolio comprised of TD's e-Series Canadian stock index and TD's e-Series Canadian bond
index.
You might point to the higher fee structure of the actively managed bank funds as the
culprit in their underperformance, but there's more to it. If we discount the higher fees,
those funds still fell short of their dispassionately indexed counterpart.
Perhaps you're wondering if the actively managed mutual funds held foreign stocks,
which—during the past decade—underperformed the Canadian stock market. If that were
the case, they don't hold them anymore. Foreign exposure, if any, accounts for less than 4%
of the total for each respective fund.
Did the fund managers shun bank stocks while they were falling in 2008, only to stockpile
them in 2009 and 2010 as they grew more expensive? Maybe. Or did they chase rising
bonds or rising stocks when they should have been doing the opposite? Again, it's entirely
possible. The bottom line is that they underperformed. Even the professionals chase past
winners.
But you don't have to repeat their mistakes. Try owning a diversified, international
collection of quality stocks or broad market indexes, in conjunction with a bond component.
Maintain your desired allocation, adjusting once a year when soaring or falling markets
cause your allocation to shift from the desired split.
You may want to use your age as a benchmark for the percentage of bonds you'll have in
your portfolio. If, for example, you're 40 years old, you may want about 40% of your
portfolio comprised of bonds, with the remainder in stocks or stock indexes.
The most important part is this: if you're adding fresh money to your investments each
month, and a specific stock or index that you own is rising in price, don't add to it. Keep the
allocation you started with by adding to bonds when your stocks rise, or adding to stocks
when bonds rise. Control your primitive reactions. Sure, somebody you know is going to
make a killing by jumping on a hot stock or sector—perhaps by picking yesterday's winner.
But investing is a marathon, not a sprint.

3. Look at last year's winners if you must. But don't buy anything based solely on past
performance. The biggest investment enemy, after all, is the one we face in the mirror each
day.