Review & Outlook

Our take on the investing, financial, & economic themes of the day

One of the Biggest Investment Pitfalls: Performance-Chasing

8 August, 2014 by Ben O'Brien in Commentary

Performance-chasing is tendency to go after the  hot, trendy areas of the market that are doing well at the moment. It seems like a good idea at first. After all, isn’t good performance the goal of investing, and so why wouldn’t you want to go after it?

Two articles from our daily roundup of links this morning demonstrate how performance chasing, ironically, usually leads to bad performance.

iStock_000016095254_Small

The first article by veteran adviser and writer Larry Swedroe is a follow up on a list of top mutual funds in 2012. Many people pick mutual funds simply on the basis of recent performance. Swedroe finds, however, that the top mutual fund performers of the year consistently perform considerably worst than average the very next year:

Performance-chasing investors—or investors who relied on Morningstar’s 2012 awards to choose managers—were clearly disappointed, at least in terms of the next year’s performance. Just two of the six funds beat even the average actively managed fund in 2013, and the average fund underperforms its benchmark index with great persistence.

He does this test for many more years and gets similar results. Part of a reason is simply reversion to the mean. If a fund has great returns in one year, chances are that the next year won’t be so great. But there is also the fact that the top mutual fund was likely chasing whatever the hot area of the market was. Given the usual cycles of the market, the best performing areas–such as internet stocks or biotech last year–tend to run out of steam and then perform very poorly for a while. So the top funds often fall into a boom and bust pattern and most investors buy in towards the top of the boom and only experience the bust.

The same sort of thing happens when investors pick money managers. The well-known adviser and writer Josh Brown, shows in an article today that advisers who are fired for poor performance tend to perform better than replacement managers. How could this be? Brown writes,

The latest stat I’ve come across concerns the hiring and firing of managers because of three-year track records, a exercise in faildom if ever there was one. The executive summary for this kind of thing goes like this: “Wow, look at those returns for the last three years! I would have made a lot more money if I was with that fund, I’m not going to miss out over the next three years!” The old manager you’re working with, who is of course a complete idiot to you now, gets fired and the new hotshot who’s been crushing it gets hired.

And then, of course, mean reversion sets in and you ended up firing the old guy at the worst moment you possibly could have, and then doubly screwing yourself by handing that money over to the new guy just as he’s statistically poised to do even worse.

So what is the alternative to performance-chasing? Two things: diversify and stay the course. You should own a full range of securities, some that are in favor and some that are out-of-favor. And then hold on to them. Do not jump in and out according to the ups and downs of the market. Your portfolio may underperform for a period of months or even a few years, but this means that it is likely poised for a rebound. Holding out-of-favor stocks and sectors means that you are often the first one to benefit when they bounce back.

Recently everyone thought real estate investment trusts (REITs) were headed for disaster until they become the best performing type of stocks in the second quarter. Before that railroads and many industrial stocks were out of favor until suddenly they weren’t. Those who held them when they were unpopular got the full benefit of the rebound rather than jumping in at the top.