The problem with chasing returns

February 12, 2014

In the constant competition for better returns, many investors chase after recent best performers.  Of course, everyone wants a proven winner but is that a good way to pick them?  As reported by James Kostohryz in an article titled ‘The Temptation to Chase Past Performance,’ there are two reasons why chasing performance is not ideal.

Investments that greatly outperform tend to lead to performance chasing, which in turn creates overvaluation. Investments that have done very well in a portion of an economic cycle usually underperform in the following period.  They are subject to the downside of the macroeconomic cycle that helped to build them up.  The fundamental reasons that drove outperformance in the first place have been priced into the current market valuation.  Therefore, it is important to avoid chasing short-term performance.

Recently the Wall Street Journal published “The Ten Best Stocks of the Past 20 years” untold numbers of investors will buy some or all of these stocks expecting them to continue to outperform.  They will likely hold on to them until the next time a large publication produces another best performers list.  These investors can count on the trading prices of these investments being inflated just as they are buying because they made the list.  This will make it less likely that they will make the list again.

Looking at returns in the past few years, you would do better in a ‘Dogs of the Dow’ strategy (picking last year’s losers) than picking last year’s winners.  That strategy has outperformed the Dow 3 of the past 6 years.

It is a good idea to create a roadmap for your investments and stick to it. A clear, solid investment plan that you follow will help you to avoid chasing trends.  Basing your decisions on emotions and past performances will increase your chances of failure.

There are many factors that affect stock and bond prices in a given year: economic health, interest rates, consumer confidence, political issues… with all of these factors in play, there is no set-and-forget way of picking investments for everyone.  We each need to follow our own plan.

http://www.smartmoney.com/invest/stocks/the-10-best-stocks-of-the-past-20-years-1331582653834/

http://seekingalpha.com/article/300606-the-temptation-to-chase-past-performance