Performance chasing causes investors to buy high and then sell low as they move their money into the new “hot” investment, repeating this flawed process. You don’t have to buy high and sell low very many times in your career to completely sabotage your retirement plans. As Warren Buffett has said, “When hamburgers go up in price, we weep. For most people, it’s the same with everything in life they will be buying—except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.”
Explore This IssueACEP Now: Vol 36 – No 12 – December 2017
This tendency is easily displayed by looking at mutual fund cash flows. When stocks do poorly, people take money out of them, and when they do well, people invest more. Stock mutual fund cash flows were negative from late 2008 to 2012 before turning positive in 2013 to 2014, well after stocks had recovered from the bear market associated with the global financial crisis. Meanwhile, those investors who bought (or simply didn’t sell) at market lows were handsomely rewarded. Bond cash flows showed the opposite, with money coming in from 2008 to 2012, then out in 2013 to 2014. Herd mentality might help groups of animals in the wild avoid predators, but it doesn’t help investors achieve the returns they deserve. Most of the time, investors are rewarded most for their willingness to sit on their hands and follow a simple, boring written investment plan over decades.
Performance chasing between mutual funds within a given asset class can be just as dangerous as performance chasing between various asset classes. Investing giant Vanguard performed a study looking at performance chasing and discovered that, between 2004 and 2013, this dangerous practice cost investors a 2 percent to 3 percent per year performance drop in every asset class they looked at.
Unfortunately, when it comes to investing, figuring out where the puck is going is just as hard to do as not skating to where it has been. Lots of self-styled “contrarians” think that just avoiding the crowds will lead to investing success, and they wander off into areas of the market that never have, and never will, perform well. To make matters even more confusing, markets do exhibit “momentum” to a certain extent. That is, something that performed well recently continues to perform well not because of any underlying economic fundamentals but simply because it has done well recently and investors are still piling into it, chasing performance.