Chasing Past Performance

Jim Lorenzen, CFP®

Morningstar data reveals that mutual funds with four or five stars captured about 75% of the roughly $2 trillion of net inflows into all “star-rated” mutual funds over the 10-year period ending December 31, 2009. If that doesn’t reveal that investors are prone to chase past positive performance, nothing will.

Cambridge Associates, a consultant for institutional investors, studied the impact of chasing past performance and the outcome of firing “underperforming funds”  –  these are funds with below-benchmark returns but not in the bottom quartile – and replacing them with “top-performing funds.”   The fired funds often began to outperform, while the newly hired funds began to underperform!   By chasing past performance, investors were mostly selling at the bottom and buying at the top— sound familiar?   In fact, more than two-thirds of the mutual fund changes were harmful to performance.

Consider, for example, the Internet bubble of the late 1990s. Imagine how chasing double- and triple-digit returns worked out for investors after the market peaked!   Remember Lucent Technologies?

It isn’t surprising.  There isn’t a day that goes by I don’t hear someone telling me they purchased a stock or fund because someone they knew had it and it `did really well’ last year.

When you hear that a manager consistently performed in the top quartile for the past five years, does it really mean anything?

Suppose you assembled a group of 1,000 money managers – or they could be beauticians or plumbers – and required each of them to make security decisions on the basis of a random process, like rolling dice.  At the end of the first year, you rank these 1,000 managers based on their returns.  By definition, 500 will be above the median and 500 will be below.  After eliminating those below the median, the top 500 continue rolling dice.  After year two, you rank them again, this time eliminating the 250 that fell below median performance.  You continue in the same way for five years.  At the end of year five, you’ve identified the top 31 managers of 1,000 who have been among the top performers for five consecutive years.

Since we know they used a random process, we know not to attribute their success to superior skill; but, in the real world the same performance information can often lead an investor to be too quick to assume that superior skill is what made the difference.   And, in our media-driven culture, many investors continue to compare their performance against results achieved by the latest investment guru, continually reallocating money from one manager or vehicle to another as the search continues for the one who will produce the superior performance – and almost always jumping off something that’s going down to grab onto something that already has gone up.

Just as Einstein’s work on relativity didn’t invalidate Newton’s laws of physics – it merely limited the context within which Newton’s laws are true – traditional investment management with its emphasis on individual security selection has been eclipsed by modern portfolio theory(MPT), which considers each asset class not as an end in itself but rather as it stands in relationship to the others.  Realizing that all investments realize market gyrations, the concept of reducing movement correlation between classes means that MPT has redefined the limits within which traditional management approaches can add value.

Few investors approach the subject of MPT or portfolio strategy.  `Performance’ is more interesting.   But, as Morningstar data suggests, short-term thinking can derail long-term financial plans.  But, then, if there’s no plan, who knows the difference?

Jim

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Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.  The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization.