When it comes to investing, it’s tempting to rely on impressive past performance as a guide for future success. After all, if an asset or fund has delivered strong returns before, isn’t it likely to do so again? However, this assumption can often lead to costly mistakes. Let’s delve into why past performance isn’t always a reliable predictor of future returns and explore a more balanced approach to investing that focuses on long-term success.
The Temptation of Past Performance
Investors are often drawn to assets or funds that have recently performed well, believing that these past trends will continue. This reliance on historical returns seems logical; after all, who wouldn’t want to back a proven winner? But financial markets are complex and unpredictable, and past performance is often a misleading indicator.
Consider the research highlighted in “The Paradox of Past Performance”. It demonstrates that high past returns are often a result of temporary market conditions, such as favourable economic environments or random good fortune, rather than an inherent quality of the asset itself. As these favourable conditions change, so too does the asset’s performance, often leading to a reversal of fortunes. Thus, high past returns can actually signal lower future returns, rather than continued success.
Why Do Investors Chase Performance?
Understanding why investors chase past performance involves recognising several key psychological biases:
- Extrapolation Bias: This is the tendency to assume that recent trends will continue indefinitely. Investors often believe that because an asset has performed well recently, it will continue to do so. This belief persists even when there is no rational basis for expecting the trend to continue.
- Outcome Bias: This bias occurs when we judge the quality of a decision based on its outcome rather than the decision-making process itself. For example, if an investment has delivered strong returns, we may assume it was a good decision, ignoring other factors such as luck or temporary market conditions.
- Career Risk: Professional investors often feel pressure to follow the crowd and invest in high-performing assets to protect their jobs and reputations. Even if they know that chasing performance is not the best strategy long-term, they may still do so to avoid criticism or losing clients.
- Instant Gratification: Investors often prefer immediate rewards over waiting for long-term gains. High-performing assets provide a quick psychological boost, whereas disciplined, long-term investing requires patience and resilience. This desire for instant gratification can lead to performance chasing, even when it’s not in the investor’s best interest.
The Pitfalls of Chasing Big Stocks
One common mistake investors make is chasing large, successful companies. It seems like a safe bet to invest in companies that have grown significantly and are among the largest in the market by market capitalisation. However, history shows that this strategy can backfire.
The article “Think Twice about Chasing the Biggest Stocks” points out that companies that enter the top 10 largest by market cap often underperform after reaching this peak. From 1927 to 2023, stocks that became some of the largest by market cap in the US market had impressive returns leading up to their inclusion. However, five years later, these same stocks were typically underperforming the market.
This suggests that while investing in big-name stocks may feel secure, it can often lead to disappointing returns when future growth opportunities have already been priced in. Expectations about a company’s future performance are often reflected in its stock price, meaning the potential for further gains is limited once the company is already highly valued.
The Complexity of a Balanced Portfolio
Many investors adopt a balanced portfolio strategy, mixing stocks and bonds to spread risk. This approach is designed to minimise volatility and provide a stable return over the long term. However, even a balanced portfolio is not without its challenges.
As Ben Carlson discusses in “A Balanced Portfolio Always Comes with Regrets”, a balanced portfolio can still lead to regret and second-guessing. For example, if stocks significantly outperform bonds, an investor may be tempted to adjust their allocation, undermining the benefits of diversification.
While diversification helps manage risk, it doesn’t eliminate the emotional discomfort of underperformance. At different times, one part of the portfolio will likely outperform the other, leading to regret about allocation choices. However, it’s crucial to remember that diversification is about managing risk over the long term, not avoiding short-term disappointment.
How to Avoid the Performance Chasing Trap
To navigate the complex world of investing and avoid the pitfalls of chasing past performance, consider these strategies:
- Diversify Wisely: Spread your investments across various asset classes and geographical regions. This can help mitigate risk and reduce the impact of poor performance in any single area.
- Look Beyond Performance: Focus on the fundamentals, such as valuation, growth prospects, and overall market conditions. Past performance is only one piece of the puzzle and should not be the sole determinant of your investment decisions.
- Stay Disciplined: Resist the temptation to frequently adjust your portfolio based on recent performance. Stick to a well-defined investment strategy that aligns with your long-term goals and risk tolerance.
- Understand Investor Psychology: Recognising psychological factors influencing your decisions can help you avoid common traps. For more insights, check out our article on “The Psychology of Investing: Key Lessons for Australian Investors”.
- Consider Professional Advice: Financial markets are complex and ever-changing. A professional advisor can provide tailored advice based on your unique situation, helping you navigate uncertainties and stay focused on your long-term objectives.
The Role of Trend-Following Strategies
Interestingly, there are instances where past performance can play a role in investment strategies, particularly with systematic trend-following strategies. These strategies involve applying strict rules and discipline to follow market trends, which have been shown to work in certain circumstances. However, these are not the same as erratic performance-chasing behaviours seen in most individual investors.
Trend-following requires a consistent and unemotional approach, contrasting with the impulsive actions driven by recent performance or market sentiment. For most investors, sticking to a diversified strategy aligned with long-term goals is more effective than attempting to time the market or chase trends.
Focus on Fundamentals for Long-Term Success
While past performance may seem like an easy metric to rely on, it is not a guaranteed indicator of future returns. Investors should be cautious of chasing recent winners and instead build a diversified portfolio based on sound fundamentals. A disciplined approach, combined with a clear understanding of market psychology, can help you navigate the complexities of investing more effectively.
If you have any questions don’t hesitate to call us or book a meeting online with Andrew or Alex today.
