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With just a few trading days left until the end of the year, many market commentators, traders, and perhaps even your friends will talk about how well the Dow Jones Industrial Average (DJINDICES: ^DJI ) and the S&P 500 (SNPINDEX: ^GSPC ) have performed the past 12 months. With six days left to trade, the Dow is up 23.79% year to date while the S&P 500 has risen 27.49%. Those are some very impressive results for one year. In fact, they're so impressive they may end up hurting investors in 2014.
I'm not predicting that there will be a pullback next year. What I'm saying is that the strong recent performance may be setting expectations higher than they should be and, thus, future returns will disappoint.
My colleague Jim Mueller recently wrote an article discussing the idea of anchoring on a stock price and how it can affect your decision-making. Well, I think anchoring can apply not just to stocks, but also to other asset classes, and even the market in general -- and that can be very dangerous.
For example, when the tech bubble was growing and new dot-com companies were all the rage, part of what was fueling that fire was the recent returns those types of stocks were having. Those returns drew in more and more investors, as they looked at past performance and not what the future may hold in terms of an actual business plan. The housing market was very similar. When it was on fire, speculators kept buying more and more homes based on what prices did in the past, not thinking about whether the increases were sustainable based on household formations and quality of the loans.
We even see this problem within the stock market, as individual stocks are pushed to absurd highs based on very little tangible information, or when investors switch funds every year as they chase fund managers' performance from the previous year.
As stock investors, we hear people saying that "past performance is not an indication of future returns," yet we can't seem to take that advice seriously. We keep looking at the past to help predict what may come in the future, but if you're looking backwards, you can't see what's in front of you.
So next time someone says the market did great last year, last month, or last week, do yourself a favor and stop listening.
Regardless of what happened in the past, the future will be based on what's happening today. If stocks are undervalued today, they'll probably rise higher in the future. If they're overpriced today, they run the risk of falling in future months. Look at what a company's numbers are telling you today, and base your buy and sell decisions on that -- not what the company has down in the past.
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