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Performance chasing, the investor's unknown enemy
What is the latest "hot idea"?
How is everyone making money with their investments now?
Did you hear how much they made on that? We've got to buy some now…
Often, emotions drive investment decisions. Investors, frequently to their detriment, have a tendency to gravitate towards what has recently done well. One of the traps in selecting investments, from stocks to industry sectors to mutual funds, is performance chasing-as assets that have provided the best returns during previous periods tend to revert to more normal returns going forward. Many investors pile into these investments just as they perform well, only to ride them as they come back down to earth. In other words, these investors are buying high and selling low.
A study by Dalbar,, a Boston-based research firm, found that between 1984 and 2002 investors in stock mutual funds held their positions for less than 30 months, during which they earned an average 2.6% annual return. Over the same period of time, the S & P 500 provided 12.2% annually. The conclusion of this study is that "Investment return is far more dependent on investment behavior than on fund performance." Although the methodology of the study may be debated and the numbers may over-state the case, the fact remains that investors frequently sell what has done poorly to buy what has done well. This decision is often counter-productive and typically results in under-performance relative to the market.
This is most devastating when participants in retirement plans select from among their options. Most participants in these plans are given little useful information to make good investment decisions. Sure, it's available, but how many people know what to ask for or even have the inclination to do so? So, many participants select investments that have done well based on the past few years returns. Then they are discouraged in three years when their account performance is sub-optimal. This may lead to reduced contributions or even reduced participation in the plan- a critical mistake because current generations will rely on the savings accumulated in these plans to supplement a considerable portion of retirement, and less invested now may considerably reduce future lifestyle.
A real-world example… a client had selected four mutual funds highly ranked by a ratings agency and recommended to him by a discount brokerage firm. However, three of the four funds ranked in the bottom 90th percent during the last twelve month period, and the client got caught in the trap of performance chasing by choosing investments based on what had done well recently even though the investment choices were valid. Or, close to our home many are talking about the huge increases in the price of waterfront real estate in coastal Alabama. It seems "everyone" has made a fortune on a small piece of property. But, how much longer will conditions be right for that to occur?
The reason the investment returns come back to normal makes intuitive sense… "What goes up, must come down". Investments that have recently performed well have likely provided a return above what they would typically offer. These cycles often run in three-year increments, so if an asset has provided returns above its long-term average for three years or more, it is likely to under-perform for the coming period. The higher short-term returns may continue briefly, but long-term this is not where you want to invest. Unfortunately, it is often this out-performance that catches the eye of investors, but much of the upside potential has likely already run its course.
What to do…
Selecting investments is not easy, whether it is being done in a retirement plan or outside of one. Often, individual investors don't have the tools to conduct the analysis they need, and rankings are often backward-looking rather than forward-looking. So, what can you do?
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