For many investors, beating the market is the Holy Grail. And for them, beating the market means finding the hottest investments and investment managers.
Superficially, this may make sense. But “performance chasing” is a dangerous trap. Why? Because today’s winners are often tomorrow’s losers.
Proof of this fact can be found by studying the historical returns of mutual funds. Research shows that few fund managers stay on top for long—and often, they go from first to worst in a few short years. As a recent New York Times headline put it: “How Many Mutual Funds Routinely Beat the Market? Zero.”
The story referred to a report by S&P Dow Jones Indices showing that less than 1% of large- and mid-cap mutual funds in the top performance quartile maintained their performance over a five-year period. Many fell into the middle of the pack, while more than 25% of them actually dropped into the bottom quartile of funds within the study period.
One reason to avoid chasing hot performers is because by the time you catch them, they’re likely to be on their way down. What’s more, the act of chasing performance is expensive in and of itself.
Think about it: To raise money for hot new investments, investors typically sell their losing investments. In doing so, they lock in their losses before those investments can recover. What’s more, they’re betting that the new investment, which caught their eye because of its great returns, still has plenty of room to rise. Often, that is not the case.
Even if the new investment does rise further after it’s bought, it will have to do especially well to compensate for the loss that was locked in in the sale of the losing investment. That’s not to mention the trading costs and taxes that are stirred up when we sell one investment to buy another.
It’s not surprising that a study from Vanguard Group showed investors who seek to “trade up” to hotter investments typically end up doing worse, not better. Vanguard’s study, which spanned 2004 to 2013, showed that shopping around for hot fund managers decreases—not increases—the odds of success. The performance of investors who bought and held investments for the long term beat that of performance chasers by a minimum of 1.6% annually, on average.
Especially in times of modest market returns, investors may be tempted to “shake things up” by moving their money from one manager to another. As the research shows, that’s usually a good way to shoot yourself in the foot.
As always, the best way to capture market returns and manage market risk is through a diversified portfolio of long-term investments, tailored to your goals. Don’t hesitate to contact me at 888-473-6931 if you’d like to discuss investing further.
