One of the most common investing mistakes is known as “chasing performance.” This occurs when investors base their buy and sell decisions primarily on how a mutual fund or asset class has performed during a previous short-term time period, such as last quarter or last twelve months.
This makes sense instinctively. After all, everybody wants to own a winner — and it’s natural to assume that funds that performed well in the past will continue to outperform in the future.
However, in practice, the opposite is true. Mutual funds that performed well in the recent past are often less likely to outperform in the near future. When investors choose mutual funds based primarily on past performance, it typically leads to buying high and selling low — the exact opposite of a successful investing strategy.
Thorough Due Diligence is Critical for Selecting Investments
Just like avoiding emotional investing, the key to avoiding the “chasing performance” syndrome when investing is to put a thorough due diligence process in place for selecting investments. This process should go well beyond just looking at past performance to delve deep into both quantitative and qualitative fund analysis.
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Quantitative analysis looks at the numbers and performance history of a fund. While this shouldn’t be the sole criteria for choosing funds, it is certainly one of the criteria. Has a fund provided absolute returns above its benchmark over the most recent one, three, five and ten-year periods? If not, are there logical reasons why and is it realistic to expect the fund to outperform in the future?
Quantitative risk analysis should be expanded to include measurements beyond absolute returns, such as Alpha, Sharpe and upside/downside capture. Such analysis is critical in truly understanding past fund performance and gauging how a fund might perform in the future.
Meanwhile, qualitative analysis examines what might be referred to as a fund manager’s DNA. Every fund manager’s DNA is different. You need to understand the process that drives a manager’s performance. All active managers underperform during some time period — the key is to determine what is driving the underperformance. Have market conditions or something else changed in the process, and is this a cause for concern? Qualitative due diligence will provide this insight and assist in helping you not to sell a manager at the wrong time.
For example, if a fund manager is taking on a high level of risk in a bull market, the fund should be expected to outperform. But if the market turns negative, this aggressiveness will likely work against the fund, leading to perhaps significant underperformance. Without performing qualitative analysis, it’s impossible to understand these factors that go beyond simply looking at historical fund performance.
Similarly, if a fund is over-weighted in a particular sector — say, consumer discretionary stocks — due to the manager’s expertise in this sector and the sector performs poorly, the fund will underperform, even if the manager’s stock selections are sound. Or if the manager has a bias toward dividend-paying stocks but these are currently underperforming relative to growth stocks, the fund will be facing headwinds regardless of which stocks the manager chooses.
When Choosing Mutual Funds Look Forward, Not Backward
There’s a reason why mutual fund prospectuses always include a disclosure that says “Past performance does not guarantee future returns.” This is a subtle warning to investors not to put too much emphasis on what a fund did in the past when making investing decisions.
As a general rule, you should look forward when selecting investments, instead of backward. This is the best way to avoid falling into the “chasing performance” trap.
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