Performance Chasing
Performance chasing is an investment behavior where individuals buy or sell securities, mutual funds, or other assets primarily based on their recent past returns. It is a common phenomenon in behavioral finance, driven by the psychological tendency to extrapolate past performance into the future, assuming that assets that have performed well will continue to do so. This approach often leads to sub-optimal investment decisions and can be detrimental to an investor's overall portfolio success.
History and Origin
The concept of performance chasing has been observed throughout financial history, particularly during periods of significant market euphoria or distress. While not formally "invented," its effects became widely apparent with the rise of widespread public participation in financial markets. A notable historical example where performance chasing played a significant role was during the late 1990s dot-com bubble. Investors poured money into technology stocks and internet-related companies that had seen explosive growth, often with little regard for fundamental valuation metrics. When the bubble burst in March 2000, many of these investments plummeted in value, illustrating the risks associated with buying into assets solely because of their recent upward trajectory.6 This period highlighted how the allure of quick gains, fueled by past successes, could lead to widespread speculative behavior among investors. The U.S. Securities and Exchange Commission (SEC) has also documented various behavioral patterns, including "focusing on past performance" as a common pitfall for investors.5
Key Takeaways
- Performance chasing is the act of buying assets that have recently performed well, expecting continued strong returns.
- It is a common behavioral bias that can lead to buying high and selling low.
- This strategy often results in lower long-term returns compared to more disciplined approaches.
- Performance chasing frequently ignores fundamental analysis, valuation, and proper asset allocation.
- Understanding and mitigating performance chasing is crucial for sound financial planning.
Interpreting Performance Chasing
Performance chasing manifests when investors observe an asset, such as a mutual fund or a specific stock, delivering high returns over a short period and then decide to invest in it. The interpretation is often a simplistic "good past performance equals good future performance." However, this overlooks the dynamic nature of market cycles and the principle of mean reversion, where assets' returns tend to revert to their historical averages over time. Investors caught in performance chasing may enter investments at their peak valuations, only to experience declines afterward, thereby missing out on potential gains from other, less recently popular assets. Evaluating investments based solely on recent performance can lead to excessive risk-taking and can undermine a well-structured portfolio.
Hypothetical Example
Consider an investor, Alex, who has been observing two hypothetical equity mutual funds, Fund A and Fund B, over the past year.
- Fund A: Returned 30% in the last 12 months.
- Fund B: Returned 5% in the last 12 months.
Alex, influenced by performance chasing, decides to invest all new capital into Fund A, reasoning that its strong recent performance indicates it will continue to outperform. She neglects to research Fund B, which, despite its lower recent return, has a diversified portfolio of undervalued stocks and a long history of consistent, albeit moderate, returns.
In the subsequent year, market conditions shift. Fund A, heavily concentrated in a few overvalued sectors, declines by 15%, while Fund B, with its broader diversification and exposure to recovering sectors, gains 10%. Alex's performance chasing led her to invest at an unfavorable time in Fund A, resulting in a loss, whereas a more balanced approach or deeper due diligence might have yielded better outcomes with Fund B. This illustrates how prioritizing recent gains can lead to misjudged investment decisions.
Practical Applications
Performance chasing is a common pitfall in various investment scenarios. In the realm of investment analysis, it often explains why investors flock to certain sectors or index funds after a period of significant appreciation. For instance, after strong bull markets in specific industries, new capital tends to flow into those areas. Morningstar's "Mind the Gap" study consistently illustrates how investor behavior, including performance chasing, can create a significant gap between the returns generated by funds and the actual returns experienced by investors. This gap often arises because investors tend to buy funds after they have performed well and sell them after they have performed poorly, effectively buying high and selling low.4,3 This behavior highlights the challenge of emotional decision-making versus a disciplined long-term investing strategy.
Limitations and Criticisms
A primary criticism of performance chasing is its counterproductive nature. While seemingly intuitive to invest in what has been successful, financial markets are complex, and past performance does not guarantee future results. Research in behavioral finance frequently points out that investors who engage in performance chasing often earn lower returns than those who adopt more disciplined strategies. For example, a report by the SEC's Office of Investor Education and Advocacy noted that focusing on past performance of mutual funds while ignoring fees can harm investment returns.2 This behavior can lead to increased portfolio volatility and can erode potential gains through poor timing. A core tenet of successful investing is to avoid reacting impulsively to market movements, a principle strongly advocated by the Bogleheads investment philosophy.1 This philosophy emphasizes consistent, low-cost passive investing over attempting to predict or react to market fluctuations, directly contrasting with the tendencies of performance chasing.
Performance Chasing vs. Momentum Investing
While both performance chasing and momentum investing involve reacting to past price movements, their underlying rationales and systematic applications differ. Performance chasing is primarily an unsystematic, emotionally driven behavior by individual investors who buy assets that have recently done well, often without a rigorous analytical framework. It is typically a reactive decision based on observed past returns. Momentum investing, conversely, is a systematic investment strategy based on the empirical observation that securities that have performed well recently tend to continue to perform well for a period, and vice-versa. It is a quantitative factor in investing, often employed by professional investors and quantitative funds, where strict rules dictate when to buy and sell based on predefined momentum indicators. The key difference lies in the systematic, rules-based nature of momentum investing versus the impulsive, emotional nature of performance chasing.
FAQs
Why is performance chasing generally considered a poor investment strategy?
Performance chasing is considered a poor strategy because past performance is not indicative of future results. Assets that have performed exceptionally well often experience a slowdown or correction, leading investors who buy in late to suffer losses or achieve lower returns. This reactive approach can undermine the benefits of compounding over time.
How can investors avoid performance chasing?
Investors can avoid performance chasing by focusing on a disciplined asset allocation strategy, investing regularly regardless of market conditions, and resisting the urge to make drastic portfolio changes based on short-term market movements. Adopting a long-term perspective and understanding one's risk tolerance are also crucial in mitigating this behavioral bias.
Does performance chasing only apply to individual stocks?
No, performance chasing applies to various investment vehicles, including individual stocks, mutual funds, exchange-traded funds (ETFs), and even entire market sectors or asset classes. Wherever there's a recent track record of strong returns, investors may be tempted to chase that performance.
Is there any situation where looking at past performance is useful?
While past performance should not be the sole determinant for investment decisions, it can be useful as one data point among many when conducting due diligence. It can help identify trends or consistent management, but it must be considered alongside factors such as fees, investment objectives, risk profile, and the underlying fundamentals of the asset.