Chasing returns around every turn is absolutely killing your portfolio.
Many investors “chase returns” by exhibiting recency bias. That is, they see what is happening right now, and they latch on hoping that it will continue. They look to ride the wave of strong recent performance. The problem lies in that that investors often hop on the wave as it’s peaking and only experience the break and the eventual washing out.
This is a problem. Many of us have heard the oldest adage in investing that you should always “buy low and sell high”. Yet, due to recency bias, most will buy high and end up selling low.
It Isn’t Just You
Let’s first take a look at some year-to-date returns for a few different asset classes (from MSCI, as of 6/28/17):
The EAFE, Emerging Markets and the US have all seen significant returns both year-to-date and going back a full year. Financial planning magazine often publishes which funds are seeing the most inflows of new money. Let’s take a look at fund flows as of June 7, 2017:
Notice the commonality? Remember that talk we had about trying to hop on a wave at the wrong time? Billions of dollars worth of assets are doing just that. The top 3 funds getting the most inflows of capital are ALL experiencing strong performance right now.
Why is this a bad idea? Billions of dollars are flowing into three asset classes with positive short-term performance. But what does this mean for the long-term?
Find “EM” (Emerging Market Stocks) on the callan chart above. Notice how many times you see it near the top because of robust returns. Now look for it on years that followed the robust returns. See what I’m getting at here? Investors are rushing to buy now into asset classes with the best recent performance. Their portfolios will now be overweight in these asset classes. When these asset classes start to face a correction, these investors will be hit harder than necessary.
This Terrible Strategy is Just as Terrible in the Long-Term
The first column represents those that invest based on which asset classes performed the best in the previous year. The second column represents investors that invest in the poorest performing asset classes from the prior year. The third represents an equal weighting across the 13 asset classes studied. Notice that the equal weighting portfolio has more robust returns. All while taking significantly less risk (as measured by standard deviation).
Don’t Chase Performance, Do This Instead
Control what you can control. You can’t accurately predict the market, no one can. The first thing you should do is establish an investment policy. Investment policies should be based on your willingness to accept risk, time horizon for investing, and your financial goals. Once established, you can create a diversified mix of assets that aligns with your investment policy. Work hard to make sure that you are sticking to this policy and not just chasing the winners.
Can you reach your goals by chasing performance? Maybe. But it’s like the guy that drives like a maniac each morning to get to work as quick as possible. Sure, on certain days he may arrive at work before you do. But on other days, he’s getting a speeding ticket or is crashing his car. Stop chasing returns.
If you want to remove your guesswork and pursue your goals along a smoother course, one in which you have all your ducks in a row, give me a call.
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Diversification seeks to reduce the volatility of a portfolio by investing in a variety of asset classes. Neither asset allocation nor diversification guarantee against market loss or greater or more consistent returns.