It’s so easy to do and seems so reasonable. If you have a mutual fund that is underperforming, why not simply swap it out for a fund that is doing well, like firing a bad employee and hiring someone new, or changing your cell phone provider because you had too many dropped calls? Unfortunately, moving your investments out of funds that have had below-average return, and moving the money to another fund with stronger performance over the past few years, sometimes called ‘Chasing Fund Performance’, has been shown to damage returns instead of improving them. This counterintuitive result is due to the fact that investing is not like managing people or choosing a good cell phone company. Excess performance in an investment fund is not an indicator of future returns.
Vanguard, the leader in low cost mutual funds, performed a study to examine the effect of chasing fund performance. The study compared the merits of a simple buy and hold strategy to a strategy that periodically sold underperforming investments and reinvested those proceeds into the funds that had performed the best over the past 3 years. The surprising result was that simply buying and holding an investment beat performance chasing in every asset class, by 1.5% to 3.5% a year on average. While the exact causes of the underperformance are not clear, it is clear that those investments that outperformed in the last 3 years are not necessarily the investments that will outperform in the next 3. In fact, historical outperformance may be an indicator of future underperformance.
So, if we cannot rely on historical performance, how can we make investment decisions? We believe that the key is to think long-term and strategically. Rather than using recent returns, think longer term when allocating investments in a portfolio. Even 3 years is a relatively short period of time and can lead to poor decisions. Longer time horizons are actually better indicators because they can reveal an investments potential performance during various economic periods. Secondly, stick to the strategy and rebalance into those investments that are relatively inexpensive or have had periods of underperformance.
Of course, the challenge to long-term strategic thinking comes when there are periods of underperformance in an investment. There is tremendous pressure to ‘do something’ to improve returns, and that usually involves selling the underperforming asset and moving those funds to something that is doing better. It seems incredibly counter-intuitive that improving returns might involve exactly the opposite. However, if we are thinking long-term, we realize that recent underperformance isn’t necessarily an indicator of the long-term potential for an investment. We may choose to keep or even add to the investment if we still believe in the long-term.
The bottom line is that managing investments if different from managing so many other aspects of our lives. Many, especially those in business, are accustomed to moving money into those areas that are performing well. In investing, that could be a damaging habit. If you are tired of chasing fund performance and would like to have a strategic portfolio, feel free to give us a call.