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Chasing returns – the story …

Misperception – that one can look at past investment returns to determine what the future return of that investment will be.

“Chasing investment returns refers to the activity of switching from a poorly performing (or average performing) investment into one that has an excellent recent return.  There are a few problems with this investment strategy:

  • “Hot” investments don’t usually stay hot.  In fact they usually come crashing back to earth shortly after you buy them.
  • Investments that aren’t doing well can make a comeback.  If you sell them at the bottom, you might miss out on any recovery.

There is nothing wrong with buying and selling investments if you have a solid investment plan and make your buys and sells based on that plan.  The worst type of investing is to buy investments after they have gone way up in value and then sell them after they have dropped in value.  This is also known as “buying on greed” and “selling on fear“.”  Source: http://www.abcsofinvesting.net/chasing-investment-returns/

So what’s the story?

You may hear advisers on TV, in the media, etc., talk about how they research securities and only have the “best” or “highest” returns in their recommendations. That sounds good since who doesn’t want the best returns? Why not catch investments after they’ve demonstrated good return – they’ve gone up?

But here’s the catch, those returns did happen, but if the investment wasn’t yet in the portfolio, investors did NOT get those returns (because it wasn’t in the portfolio yet). The adviser put the investment into the portfolio AFTER they noticed it had the best return relative to something else they did have in the portfolio – but they took that old investment out because it didn’t have that higher return … or the return they expected. So you see the shell game? Investors DID get the returns of the lower performing investment because that IS what WAS in their portfolio, until it got switched out.

What this means is that such an investor is not getting the past returns of investments they weren’t in, regardless of how good (or bad) those returns were, only the returns AFTER they invest … investors ALWAYS get past and future returns of those investments they actually have held.

So the story sounds good – except it really is a story about always being too late for the past, and the future is always uncertain. One might call this market timing (why this is a bad idea). Thus, chasing returns gives the illusion of higher returns based on past returns, and switching to a new illusion with a new replacement holding when returns aren’t persistent in the prior holding.

You have seen, even though you don’t recall, this standard disclosure: “Past performance does not guarantee future returns.” I agree with Solin’s article that better wording would be “Do not expect the fund’s quoted past performance to continue in the future. Studies show that mutual funds that have outperformed their peers in the past generally do not outperform them in the future. Strong past performance is often a matter of chance.”

Outperformance is called Alpha, a statistical term that is both shrinking and getting harder to achieve. Academic research finds this to be more likely luck versus skill which is why it doesn’t persist consistently.

I would also point out that outperforming peers is NOT a goal – the real objective of investing is achieving YOUR goal … and that has more to do with savings rates and spending rates that it does returns (hint: you can control how much you save or spend).

So how should you invest? What is different from chasing returns?

Once one understands that past returns do NOT indicate future returns – in other words, the future is always unknowable and the past doesn’t mean the future will be the same – then it becomes clearer that FUTURE RETURNS ARE UNPREDICTABLE because the future is unpredictable.

Ongoing study by Standard and Poor’s called Standard & Poor’s Indices Versus Active (SPIVA) shows that some funds do outperform indexes … HOWEVER, and a big but, persistence to do so goes away – in other words, managers don’t consistently year after year after year outperform – so they again underperform.

Rather than chase returns, simply invest in broad indexes and get index returns as the markets give them – good and bad. One then gets the indexed returns. This approach persistently gets the indexed returns. The strategy of rebalancing works then to sell high and buy low. Focusing on what market dimensions provide expected returns is the forte of Dimensional. Their research work is summarized on their website.

Consistent returns, that match the markets, means you don’t get the occasional outperformance, but you also don’t experience underperformance too … broad market dimension indexing means you get the returns the markets give; yes, good or bad. And that’s why you are diversified … different dimensions move differently with the same unexpected news.

Moral of the story:

One can wish for good market returns all the time. But that is not how the markets work. Markets are the result of all market participants buying and selling (it always takes two – a buyer and a seller) which sets the investment price at that moment.

Unexpected news is what moves prices either higher or lower based on what was previously expected. Rather than adhere to the story of chasing returns (that’s not how it’s described – but that is the result of action), your story is simply to let the markets work over time and that you’ve focused on those dimensions of the market that evidence suggests returns come from.

This approach provides the ability to dial in the level of risk you are most comfortable with by focusing on just systematic risk (highly encourage you to read this) and diversifying away unsystematic risk.

Photo By Pseudopanax at English Wikipedia (Own work) [Public domain], via Wikimedia Commons

In the interest of disclosure: I do use DFA with most clients (not a fund requirement, but a business decision I’ve made). This article is not a solicitation; simply an explanation of the basic philosophy discussed.


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