When it comes to investing, watching investors chase past performance is as timeless as having a hot dog at a baseball game. For as long as there’s been a stock that has performed well, there have been investors standing in line waiting to get in on the action after its initial success.
And I understand why it happens. As an investor, I know it feels good to buy a stock that has done well in the past because it seems like a safe bet; surely that stock will only continue to do well into the future.
We tend to believe this thanks in part to recency bias, or the inclination to believe that just because something is a certain way today (or was in the recent past), that it will continue to be that way tomorrow. But we also believe it because we’re trained to think that judging past performance is a great way to make decisions in other aspects of life.
That’s bad news for investors, especially considering that when it comes to the financial markets, yesterday’s winner is often tomorrow’s loser.
How Our Decision-Making Process Mis-Leads Us
To get a better understanding of why all investors are tempted to chase performance, consider a common decision-making process.
Recently I decided my son Blake needed a tee-ball set. So I went on Amazon to do some research, decide on a product, and make the purchase. In doing so, did I compare the manufacturer’s description of various tee ball sets? Of course not!
But I did immediately compare users’ past reviews of various tee-ball sets, rationalizing that I wanted the highest rated tee-ball set with a decent number of reviews for a reasonable price. The set I bought arrived a day later, and my son received that particular product because I made a decision based on past experiences of other people with the same product.
A Reliance on “Past Performance” Can Work When We’re Shopping – But Not When We’re Investing
It was these past reviews that gave me confidence that my son would have a positive experience with the tee-ball set as well. Why did their reviews give me confidence in my decision? Because I’ve often used people’s reviews in the past when making a buying decision and it usually serves me well.
That is, the past performance (reviews) of items I’ve purchased has usually been a strong indicator of my likely satisfaction with the same item.
There are many other aspects of life where past performance can serve as a strong predictor of future outcomes – picking a restaurant, a doctor, or a university, to name a few. It’s these
experiences that create our instinctive nature to use past performance in predicting future outcomes in all aspects of life.
What’s unfortunate is that investing doesn’t play by the same rules…and that’s what makes disciplined investing so difficult.
Why Past Performance is a Poor Predictor of Future Investment Returns
The chart below illustrates the returns of different asset classes over time. In looking at the chart and comparing returns of different asset classes from one year to the next, you can quickly see that knowing how an investment performed in the past gives you very little, if any, information about its future performance:
Why doesn’t an evaluation of past performance work with investing when it’s reasonably useful in other areas of life? There are two primary reasons – one economic and one less scientific.
Investing, at a high level, happens when a large group of buyers and sellers with different sources of information and opinions engage in an exchange of securities or assets in a financial market. That information and the expectations investors have both change over time. That, in turn, causes investors’ buy/sell decisions to change as well.
This variance in opinions among investors cause the best/worst performers to rotate for non-economic reasons. Put it all together and past investment performance tends to be more random and less predictive of future outcomes.
The other more economic reason past performance is a poor predictor of future investment returns is rooted in the fundamentals of investing. In general, the better an investment performs over a period of time, the higher its valuation will be relative to the beginning of the period. The higher an investment’s current valuation, the lower its future returns will be (all else being equal). Strong past performance actually often contributes to lower expected future performance.
The same is true of poor performance over time, which lowers an investment’s valuation and thus increasing its chances of higher future returns. This means past performance is not only a poor predictor of future outcomes in investing, but it can also lead investors down the wrong path at the absolute worst time.
Making investment decisions based on past performance actually encourages investors to buy more expensive investments and sell cheaper ones — and we know successful investing mandates the exact opposite behavior.
How Can Investors Turn the Tide?
The first step to curbing the inclination to chase past performance is awareness. Know that we, as humans, share an instinct to believe that past investment performance is a good predictor of future results. I have it, you have it, we all have it. And generally speaking it’s a good instinct in life in general – but not when it comes to investing.
The key differentiator in determining why it affects some investors more than others is education. Those with the most knowledge and the most awareness are the investors who are least likely to give into the temptation to chase investment performance. They understand its pitfalls and false promises. Educating yourself on your own natural tendency is the best thing you can do to prevent making this mistake with your own investments.
The second step is asking yourself the question, “If past performance won’t help me make better investment decisions that increase my chances of better results, then what will?” The answer lies in focusing on the areas of investing within your control.
That focus should start with setting financial goals – or why you wish to invest in the first place. Then, consider an allocation of stocks and bonds that aligns with your comfort with risk and your financial goals. Finally, by periodically rebalancing your portfolio and keeping investment expenses low, investors will significantly increase the chances of achieving their financial goals – which is truly the most successful investment outcome you can achieve.
There are many life experiences that teach us that past performance is the best predictor of future outcomes. It’s why all investors, professional and otherwise, are programmed to apply the same logic to investing. But if investors can demonstrate the awareness to why the logic fails in investing and shift their focus towards that which they can control, they can then start to increase the chances of better future investment results.