Hindsight is always 20/20. This phrase is frequently cited when looking at stock prices and past market performance, often with regret that, as an investor, you missed out on an increase in your portfolio value. This same hindsight, then, is extrapolated forward to forecast which stocks or mutual funds will perform well in the future. We refer to this phenomena as performance chasing. Unfortunately, too many investors are convinced past performance is a prime indicator of what might transpire with regards to best performers going forward. This is unfortunatebecause, statistically, the investments that have done the best in the past do not continue to perform at those same levels in the years to follow.
The reason many investors experience the investor behavioral gap is because of adverse human behavioral tendencies. Most humans by their very nature tend to be serial interpolators, which simple means we take recent circumstances and project them indefinitely into the future. An example of this would be to take a stock like Amazon and say that it has returned 60% over the past year and will continue to do well in the coming years simply because the business seems to be doing well and the stock has been going up. The urge to chase performance leaps into the equation at this point and entices an investor to see those past return figures and then inevitably envision what value the investment might be worth in 3, 5, or 10 years if the current trend continues.
The image below illustrates the divergence in total return and investor return for a mutual fund selected from Morningstarâ€™s mutual fund database. The fundâ€™s 10 year total return was +3.9%, but the 10 year return for the individual investor was an awful -15.4% - an extreme and devastating difference. The fundâ€™s net cash flow tells the story of the discrepancy. Investors piled into the fund during its run-up between 2006 and mid 2007, with most inflows occurring near the fundâ€™s peak value. Investors then fled as the fundâ€™s returns plummeted, with most outflows occurring near the fundâ€™s bottom. This type of behavior is all too common with individual mutual fund investors as they tend to chase performance, buying high and selling low. Performance chasing is one of the biggest reasons investors under-perform over the long term.
Emotions tend to dictate a lot of decisions that most of us make. This can have long-lasting detrimental effects on an individualâ€™s investment portfolio. Most individual investors buy when they should be looking to sell and have a tough time picking an exit point for their investments which should be sold. A rational, long-term, forward-looking investment philosophy is more important in managing your assets than knowing how certain investments did yesterday or over the last five years. In an ever-changing marketplace, the past is the past, and has little to no bearing on what will happen to your investment portfolio in the future.
Remember, working with a fee-only financial planner and investment advisor will go a long way in avoiding behavioral pitfalls that so many individual investors face. Before making an investment, always remember to discuss with your own fee-only advisor.