Every investor has heard the disclaimer that past performance does not guarantee future results.
Nevertheless, a large percentage of investors have always ignored the fact that there is no correlation between past and future performance. For them, chasing past performance is the name of the game—and it’s a losing game.
Like walking down the street backwards, chasing past performance may work out temporarily, but it tends to end badly. It’s human nature, perhaps, to be drawn in by past performance. Investors plunk their money into last year’s top mutual fund. Or they pursue hot market sectors—such as the dot-coms in the late ‘90s and real estate several years later.
Chasing last year’s winners—or last month’s winners—is perhaps the costliest mistake investors can make. Research from S&P Dow Jones Indices underscores the point. As of September, 2012, 681 mutual funds were in the top quartile of performance. Two years later, more than 90% of them had dropped out of top-quartile territory. What’s more, over a five-year period, more than a quarter of the top-quartile funds fell into the bottom quartile.
It’s impossible to know ahead of time which of the top performers will remain top performers, and which will sink to the bottom.
Our advice is simple: Work with a financial advisor to create an investing plan based on your unique goals, timeframe and risk tolerance. And then stick to it!
As you may know, having a properly diversified portfolio is the most effective way to achieve the performance your goals require while taking on the minimum necessary risk. One reason people chase performance is that they lose sight of how the components of their portfolio complement each other.
An investor might be tempted to sell the asset with the lowest return and replace it with a more promising one. But a properly diversified portfolio is actually expected to have components that under perform from time to time. These provide a counterbalance to the rest of your investments. When stocks fall, for instance, bonds may be expected to rise, and vice versa. With a diversified portfolio, you are never bound to the performance of any one asset class.
A cardinal rule of investing is to buy low and sell high. Chasing performance virtually guarantees that you will achieve the opposite. Acting on emotion, most investors sell their losers and use the proceeds to buy investments that have already soared in price. This is a great way to shrink—not grow—your assets. And that doesn’t even take into account the tax and expenses triggered by frequent buying and selling.
Keep in mind that the times when the markets are struggling are the times when we must exercise the most discipline. As Acorn co-founder Todd Tarantino says: "When the news on TV and in the papers is all about poor market performance, a great "tip" is: ‘Don't open your statement!’ It is reporting facts you can't change and can only create more stress. Stick with your plan and avoid those urges to make changes based on short-term market changes."
At Acorn, we strong espouse a disciplined and patient investing approach. All investments will have their short-term ups and downs. Over time, though, good quality investments should appreciate. In other words, long-term rewards require a patient, long-term outlook. Keep that in mind the next time you’re tempted to buy the hot investment of the moment.
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