Every big-city commuter knows the feeling: The cars ahead of you haven’t budged in ages, but the lane to your right is moving along smartly. You ease into the “fast” lane, only to find that it’s now ground to a halt—while your former lane zips forward.
That’s an apt analogy for what happens when investors chase performance. When a holding is stagnating or losing ground, it’s tempting to jump to a more promising stock, fund or sector. So we “change lanes”—only to find that, like that luckless commuter, we’d have been better off staying put.
As we’ll spell out below, performance chasing is self-sabotaging behavior. But it’s also very normal. As humans, we’re wired to suspect that the grass is always greener on the other side of the fence. But giving in to the performance-chasing impulse is one of the most costly mistakes you can make as an investor.
Consider the fact that the average stock-mutual-fund investor has underperformed the S&P 500 Index by an average of 8.64% every year for 30 years, according to research firm Dalbar, Inc.
One of the primary reasons for this performance gap has to do with—you guessed it—performance chasing. The typical fund investor, forever jumping from one fund to another in search of superior returns, loses the return he’d earn by staying put.
The performance gap is well-documented, by the way. A similar study by The Vanguard Group, the investment management company, found that large-cap blend investors (seeking a mix of value- and growth-oriented mutual funds) would have median returns of 6.8% over 10 years by holding their investments, but just 4.5% if they had chased performance by continually jumping to hot funds.1 And there are many others [link to our website].
Impatience is even more expensive than it may seem. Performance-chasing investors often sell depreciated holdings to buy those that are appreciating. In so doing, they make the mother of all investing mistakes: selling low and buying high. When one sells a sinking investment, they make a paper loss a real, irretrievable loss. And their shrunken capital buys them smaller stakes in their next, possibly overpriced, investment. This process helps to explain why so many performance chasers end up in a downward spiral.
There’s nothing unusual about wanting the best performing investment or investment manager. The problem is that in the investment world, “best” is a very temporary description.
A recent study from S&P Dow Jones Indices found that 0% of large- and mid-cap mutual funds in the top performance quartile managed to maintain that performance over five years. Even worse, more than 28% of those formerly hot funds dropped into the bottom performance quartile.2
We call this “first or worst” phenomenon: Sector concentration is fun while it’s working, but painful when it’s not.
The same phenomenon can be seen across asset classes. In 2013, high-yield bonds bested all other fixed-income classes with a 7.4% return. The next year, they were near the bottom with a 2.5% return. In 2013, small-cap stocks beat all other types of equities with a 38.8% return. By 2014, their return of 4.9% landed them in the middle of the field.3
Performance chasing is the polar opposite of a sound, strategic
investment strategy. The most successful long-term investors create diversified portfolios that are tailored to their goals, risk tolerance and time horizon. And then they stay the course, giving those investments plenty of time to do their work, rebalancing by selling the winners to replenish the under performers. We like to call this the “Robin hood approach.”
As humans, we are programmed to be ever on the lookout for the greener hillside, the faster lane of traffic and the hotter investment. Exercising patience and discipline? That requires some real willpower. The reward: a much higher probability of achieving your goals over the long run.