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Chasing Performance: What It Is and How to Avoid It

Today’s post is a simple one. No complicated math. No graphs. Just a simple warning about one of the investing errors I see committed most frequently: Chasing performance.

What does it mean to chase performance?

Exactly what it sounds like. An investor is chasing performance anytime he makes investment decisions favoring a fund (or stock or anything else) because it has performed well recently.

Two common examples of chasing performance:

  • Picking funds for a new IRA or 401k based on recent performance.
  • Making an annual contribution to an IRA and allocating it to your “best fund” (that is, the one that has gone up the most recently).

Why is it a mistake to chase performance?

Historically, a period of above-market performance for a given fund will be followed (eventually) by a period of below-market performance. In statistics jargon, this is referred to as “reversion to the mean.”

Many investors make the mistake of thinking that a fund with a great track record over the last year, 3 years, or 5 years, is a “good fund.” So they invest heavily in the fund precisely when its risk of underperformance is highest (that is, immediately after a period of consistent overperformance).

I know that some investors have a habit of chasing performance every single year with their IRA contributions (investing in whichever of their funds has climbed most recently). This is, unfortunately, a nearly surefire way to underperform the market.

My advice? If you’re going to try and pick from actively-managed funds, don’t base your decision upon something as ephemeral as recent returns. Looks for things that tend to stick around (low costs, low manager turnover, etc).

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Comments

  1. I sometimes remember with a chill the year 2000, when I considered making my first investment in the stock markets from my cash savings. An online fund selecting supermarket suggested the “Henderson Technology Fund” (UK fund) for someone of my “risk profile”.

    Apparently that meant “someone who plans to lose it all” because it fell 95% or so in the years that followed (from the top of my head.

    I never got around to investing that year – I’d like to say it was skill but in those days it was probably equally apathy. So it proved a good AND inexpensive lesson in the dangers of mean reversion.

    Later years I saw the same thing happen with property and natural resources, and I was able to avoid making that mistake I almost made.

    About the cheapest lesson I ever had in the stock market! 🙂

  2. Wow. What a narrowly-dodged mistake. It’s great when you get a chance to learn investing lessons without having to lose a bunch of money.

    I’m pretty sure that that’s what drives me to read so much about investing: I’m hoping to learn from other people’s mistakes rather than having to make them myself.

  3. As always, past performance is not an indicator of future (or even current) results. Great reminder!

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