How often does it happen? You are at a toll plaza looking to quickly exit, you pick a certain toll booth lane and suddenly you notice that the queue at the other toll booth lane is moving faster. So you quickly switch the queue, only to find that the earlier queue is now moving faster. Haven’t we all been there – cursing ourselves?
Similarly, a lot of investors see this happening with their portfolio. To increase their portfolio returns, investors fall into the trap of chasing funds purely basis their recent past performance. All mutual funds discretely state in their marketing collaterals that past performance may or may not sustain, yet funds that delivered superior returns over the recent past tend to attract relatively higher cash inflows. Have you also been doing this – when a fund underperforms, you are tempted to liquidate your position and switch to a top performing fund? Then even you are chasing performance.
The hunt for easy signals
It has been observed that investors while making their investments swear by the star rating provided by different agencies. These star ratings are a result of a composite score considering the risk return profile of a fund, some consider other factors as well but overall past performance plays a major role in ratings. The argument against usage of star rating is that they include past performance and investors use these rating as easy guidance for their investing journey. Back in 2010, Don Philip from morning star said the following:
“The Morningstar rating for funds is a grade on past performance. Period. No one at Morningstar ever claimed that the stars have predictive power or ever ran an ad telling investors to follow the stars to riches.”
Investor seek ‘easy to understand’ or eye grabbing indicators. It’s imperative for investors to understand that relying on such signals doesn’t shore up wealth, instead investors should use such signals in addition to detailed research.
This practice begs the question why do investors do what they do. One seemingly plausible explanation is that human brain has evolved to recognize patterns, it has helped humans survive and evolve. When we see any information, we try to create a pattern out of it, it helps us to process the information faster and take decisions. Sometimes these patterns hold true and sometimes they are merely a figment of imagination, but seeing patterns when it is not there is preferred over not seeing patterns.
Sneak peak into pitfalls of chasing past performance
A common practice that investors follow is that they look at past 1 year performance and invest in the top ranked schemes. We tried to replicate the same, based on past year’s performance (i.e. in 2010) we selected top 5 funds across categories (Large Cap, Mid Cap, Small Cap and Multi Cap funds) and plotted how these 5 funds fared across period in terms of ranking. The results speak for themselves.
The top 5 funds identified basis previous year performance went onto become bottom 5 performers at some point in time during following 10 years. Although these funds managed to reclaim the status of ‘Top 5’ funds (basis past 1 year performance) later sometime, but the investor may have missed out on this due to the chasing past performance strategy.
Intrigued as to why this happens? The answer lies In a famous book titled ‘Thinking Fast and Slow’ by Daniel Kahneman, the author has spoken about a statistical concept regression to mean- which says that any extreme events will revert to mean over a period of time. Simply put assume a fund that has delivered stellar/worst returns in one period, over the next period it will revert to mean. Investors need to bear in mind that regression to mean is a force to reckon with.
Some might argue that we cherry picked the timing to suit our study but that is not the case as this study spans across a 10yr period. Additionally, similar results were observed across 3year performance intervals (instead of 1 year in this case).
Simulating investor returns
To provide more insights on how prudent this strategy is, we simulated a general investor’s behavior and evaluated his portfolio performance. The simulation assumes that an investor looks at past performance of the scheme and invests in the scheme that has performed the best.
An investor would have been better off staying invested in single fund tracking a low cost, broad based index. Investor also need to factor in the cost of churning the portfolio and the tax implication arising due to capital gains.
Behavioral Gap
We would all agree in the investing philosophy ‘Buy Low, Sell High’, but do we follow it in principle? A look at the actual fund flows shows a completely opposite picture. Funds that have performed well attract more cash inflows, while the funds that have performed poorly attract outflows indicating investors ‘Buy High, Sell Low’. Many studies have indicated that due to market mistiming, an average investor’s return lags that of fund returns.
“Money flows into most funds after good performance, and goes out when bad performance follows.” (John Bogle)
Imagine you sitting in front of your laptop scrolling through the performance of various funds and then selecting a fund. The performance you saw on the screen is called ‘investment returns’- it has an underlying assumption that you invest at the beginning of the period and then leave the investment untouched.
While the return noted by an investor is called as ‘investor return’- these are the real returns an investor realizes. More often than not, it lags the investment returns. This difference between the 2 returns is called as ‘Behavior gap’.
To provide further insights we simulated the behavior gap – Based on the monthly cash inflows/outflows in a fund we identified how a typical investor would have fared (investor returns), while the fund performance is basically performance of the fund over given time. For the 5 year period ended Jan 2021, the average investment return noted was 13.10%, while the average investor was 8.85%. The investor’s average returns lagged the fund returns by a whopping 4.25%.
Surprised? Blame your investing decision! Investing is driven by human emotions. Very often investors mistime the markets- They start investing when the markets are at highs and stop investing when markets are falling. This results in behavior gap.
Conclusion
To quickly sum up- Due to the dynamics of the market, consistently outperforming maybe difficult. Investors should select funds that are aligned to their style and allow the strategy to play out. Practicing ‘neglect’ has shown to benefit the investor. We need to relearn that sometimes ‘doing nothing’ is rewarding. Next time you find yourself tempted to switch to a better performing fund remember ‘You can’t drive a car looking in the rear view mirror’.
Disclaimer and Risk
This article has been issued on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The fund/funds mentioned herein is/are for explaining the concept and shall not be construed as an investment advice to any party. The information / data herein alone is not sufficient and shouldn’t be used for the development or implementation of any investment strategy. It should not be construed as an investment advice to any party. All opinions, figures, estimates and data included in this article are as on date. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken on the basis of this article. Investments in securities markets are subject to market risks, read all the relevant documents carefully.
