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Three Signs of Chasing Performance
Despite the pervasiveness of the “Past performance is no guarantee of future results” disclaimer and the decades of research that support it, investors often behave as though past performance does predict the future. Here we provide three behaviors that suggest when you may be guilty of chasing past performance in making investment decisions.
#1 Using language that projects past returns
Saying “The market is going down” rather than “The market went down last quarter” indicates a subconscious tendency to project past returns into the future. Even though the data show little relationship between managers’ past and future performance, saying that a manager “is underperforming” suggests that you believe the past performance is persisting.
#2 Second guessing your asset allocation
Periods of poor performance are inevitable. While it is normal to wish you had invested more in asset classes that rose significantly, and less in ones that fell, that regret should not affect your investment decisions. Most investors have a well-defined process to determine their asset allocation. Do not allow recent performance to tempt you to deviate from it.
A predilection to decrease holdings that performed poorly shows an implicit assumption that the news or events that caused investors to revise their outlook will repeat, causing additional downgrades in the future. The better response to an unexpected move (up or down) is to compare the change in price to the change in fundamentals, and then decide whether to buy, sell, or hold.
The same temptation exists with active portfolio managers. Past performance was only one factor in your hiring decision. It should not be the primary reason for firing. Instead, use the manager’s recent performance in conjunction with your other evaluation criteria to update your assessment of the likelihood that the manager will add value in the future.
#3 Past investment decisions: consistently buying after prices rose, and selling after prices fell
Examine your past asset allocation changes and manager terminations to confirm that they were consistent with your investment philosophy. If they were not, modify your decision-making process.
Was there a pattern of increasing allocations to asset classes that had risen recently, and decreasing allocations after a decline? If so, it’s an indication that you have been extrapolating performance.
Was there a pattern of quickly terminating managers after a period of underperformance? If so, it’s a sign that you may be placing too much weight on poor results as an indicator of lack of skill.