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Past performance is the single greatest predictor of future success, isn’t it? When it comes to investing, nothing could be further from the truth. Studies show that a mutual fund’s recent performance has almost no correlation to its future performance. The fund could go up, or it could go down. Unfortunately, many investors fall prey to the trap of chasing past performance.

What is chasing past performance?

Chasing past performance means buying investments (especially mutual funds) because returns for the last year, three years or even five years beat the market average. In your research, you might see that a mutual fund yielded double digit growth during a time frame that the stock market remained stagnant. These funds look tempting, but if the fund does not fit into your overall investment strategy, it’s a dangerous choice.

Why investors chase past performance

Investors jump on hot performers because they believe that a stock that has performed well recently will continue to offer robust future returns. Investors choose top performers because  all people suffer from a phenomena known as recency bias – the tendency to weigh recent events more heavily than history. It is nearly impossible for investors pick a fund that had negative returns the previous year; we would rather choose a fund that performed in the double digits.

Chasing past performance presents particular investment dangers because most investors don’t think that they chase past performance. Unfortunately, most investors (even professional financial advisors) are wrong. Morningstar reports on both the fund’s performance, and investor performance within the fund. For nearly every mutual fund, investors underperform the fund. Investors tend to buy high and sell low as they chase past performance.

For example, compare Fidelity’s IT Services Portfolio returns to the average investor returns over different time frames. Investors in the fund, underperformed the fund by .8% compounded over ten years, and by more than 5% over a three year time frame.

Morningstar shows that investors underperform their funds

Morningstar shows that investors underperform their funds

Just how dangerous is chasing past performance?

An investor who invests $10000 a year and earns compound adjusted growth rate of 7% will have over a million dollars in their portfolio within 31 years. If chasing past performance erodes their growth rate to 6%, it will take 34 years to surpass the million dollar mark. Even a small performance difference costs a lot of time.

What to do instead

At DIY.Fund, we equip investors with the information they need to overcome investing hurdles. With this in mind, we recommend the following steps that will help you prevent chasing past returns and maximize your returns.

Commit to your investment strategy

Every investor should develop and stick to an investing strategy through bull and bear markets. A disciplined investing strategy insures that you’ll take the right actions at the right time. It’s not always easy, but it is the best way to invest.

Rebalance your portfolio

Rebalancing your portfolio will keep you from the buying high and selling low.  If you’re interested in purchasing a stock or a mutual fund, be sure it fits into your overall portfolio strategy, including your sector allocation. The information available at DIY.Fund can help you assess whether or not you’re making the right decision.

Continue investing

It can be tempting to pull your investments into cash when the markets fall (or worse, allocate all your money to the only assets that didn’t fall), but this is the time when investors have the opportunity to make outsized returns. At DIY.Fund we will soon make it easier than ever to help investors make outsized returns by implementing a tax loss harvesting tool that will help investors benefit from both good and bad market periods. In addition to tax loss harvesting during down markets, it’s critical to continue investing using your normal allocation strategy, so you can reap the benefits of low prices when the markets recover.

Remember your goals

Your personal goals should drive your investing strategy. If you remember why you’re investing, you’re more likely to stick to your investment strategy. When your strategy fits your goals, you will find it easier to make “boring” investment decisions that allow you to meet your goals rather than “exciting” decisions that lead to underwhelming performance.

Photo Credit: Freepik