How Performance Chasing Can Lead To Disaster

Here’s an amazing anecdote that ought to blow your mind: over the decade ending 2009, the best performing diversified stock mutual fund in the U.S. generated 18% annual returns. The returns achieved by the average investor in that fund? A negative (11%) annually!

Doing the math, this means an investor who’d just bought and held a US $10,000 investment through all the ups and downs would have ended the decade with $51,900. Instead the average investor wound up with a measly $3,200.

How can something like this possibly happen? The answer’s quite simple: investors were chasing performance. It was a volatile fund, up 80% in 2007 for instance, then down (48%) in 2008. On its own, volatility shouldn’t matter to the long-term investor. But one seemingly inescapable aspect of human nature is the herd instinct: investors flocked to the fund after its hugely positive performance runs, and bailed out of it after its negative stretches. This desire to “time” the fund’s performance led to an overall disaster for the average investor.

Though this is an extreme example, investors should know that the performance gap isn’t specific to just this one fund. It has been demonstrated throughout the years: one study showed that between 1991 and 2010, the average stock-holding mutual fund returned 9.9% a year, while the average investor in those funds earned only 3.8% a year. The result was that a $10,000 portfolio would’ve turned into $66,300 on average if bought and held, but the average investor only wound up with $21,200.

While we don’t have data specific to Indian mutual fund activity, it’s an extremely important lesson to investors no matter where they live and invest. One of the most difficult aspects of investing successfully is overcoming our own various behavioural instincts. Foremost among these is honing your emotions so that, as Warren Buffett has famously said, you get “greedy when others are fearful and fearful when others are greedy.” Average investors in these funds did the exact opposite – they got greedy along with everyone else and bought after huge run-ups, and got fearful along with everyone else and sold after huge sell-offs. It’s admittedly pretty difficult to train yourself to overcome this instinct, but it pays to keep a healthy scepticism towards massive performance runs.

One easy way to think about it in real-world terms is as follows: let’s say a carton of milk normally costs Rs. 65 at your local market. If you go to the market and see that same milk selling for Rs. 50, do you get excited and buy several cartons, or do you get concerned and run away? What about with vegetables? Fruit? Cleaning supplies? You probably tend to get more excited when you see low prices at the market, and use it as an opportunity to load up on extra supplies. Meanwhile, if that same carton of milk had been suddenly marked up to Rs. 80, you might hold off on buying it and see if a substitute brand is available, or another store has it at the price you like, or you may wait until you come back a few days later to see if it’s back to the normal price.

This is exactly how you should approach investing in the stock market. Get a little more excited when things sell off, and a little bit more nervous/sceptical when prices rise.

It turns out the same thing applies to picking fund managers. Another study showed that, of managers who had been top quartile performers in the period, 93% of them had spent at least one 3-year period over the prior decade in the bottom half of all funds in performance. Everyone underperforms at some point!

So if you see blazing performance in the short term, don’t rush to throw your money in the fund. If you see poor performance in the short term, don’t rush to pull all your money out (or, if you aren’t already invested in that fund, don’t just blindly avoid it because of that short-term underperformance).

All this isn’t to say that it’s always a bad idea to buy something that’s already gone up. It’s just that you should step back and ask yourself: was my interest piqued just because it’s gone up? Or did I have an alternate reason? If not, then that in and of itself should be a signal that you ought to carefully reconsider the investment rationale. Take a longer view of that manager’s performance and think about whether that manager has remained consistent with its stated style. Think about whether that manager has the process, philosophy, and the people necessary to ensure they end up outperforming more often than not in the future.

As always, at Quantum we encourage equity investors to stay put for the long term. As long as you’re with a manager you trust, you should resist the urge to try “timing” the manager’s performance, as that could make you substantially worse off down the line than you otherwise might have been!

This article is not a recommendation to buy or sell units of any particular fund.

Disclaimer, Statutory Details & Risk Factors:

The views expressed here in this article / video are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering / communicating any indicative yield on investments made in the scheme(s). The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the reader. The article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date. Readers of this article should rely on information/data arising out of their own investigations and advised to seek independent professional advice and arrive at an informed decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.

Above article is authored by Quantum.

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