Chasing after investment returns is something we’ve all done. It’s human nature to look at an investment that’s been red hot and think that string of over performance can continue into the future. Buying an investment that had an outstanding year and selling an investment that underperformed the market sounds like a smart move. Unfortunately, doing the complete opposite of what I just described is actually the better move. We’ve all heard the saying “Buy low and sell high,” but why do most of us buy high and sell low?
To shed some light on this issue, let’s take a look at market investment by asset class versus what the average investor earns. If we look at the annualized returns over the trailing 20-year period through 2015, domestic stocks and bonds have made 8.2% and 5.3%, respectively. During this same time period, where inflation grew at 2.2%, the average investor earned a measly 2.1%. And why does this happen? Well, some of this underperformance has to do with investors being too conservative and keeping their money in cash or other low paying instruments, but the glaringly obvious answer lies with the typical investor chasing after historical returns/performance in the hopes that yesterday’s glory will bring tomorrow’s fortune. As you can see, that’s rarely the case.
A classic example of chasing returns seems to happen in sector- and country-specific funds, where returns can be in the triple digits one year only to lose half its value the next. Of course, chasing returns can happen on the downside as well. Haven’t you seen a stock that used to trade for $100 a share and then a year later is around $4? It’s easy to tell yourself if the stock was worth $100 once before, it can get back to that level again, so why shouldn’t you buy? This is another example of chasing historical returns, but this feels a lot safer because the investment you’re buying didn’t just come off a banner year making 100%; it has fallen on hard times and has been left for dead. In this example, the right side of your brain tells you the risk is minimal because the downside is only $4 a share where the upside could be $96 if it gets back to its previous high. And when the stock is cheap, we tend to buy more of it so we can increase our chances of making a big profit. Of course, if the stock goes from $4 to $1, you just lost 75% of your money. Maybe there’s a fundamental reason why this stock is at $4 a share. Just think of all the Internet stocks that were flying high in the late 1990s with triple-digit stock prices only to drop like a stone on their way to becoming worthless a few years later.
When you chase after returns, you may have nothing but the best intentions, but these best intentions can sometimes be disastrous. Just think of all the people in this world who struggle with their weight and just want to be thin. The advertisers of various weight-loss products know how badly you want to be thin and tell you they have the next best thing. Although you may be skeptical, the lure of being thin is too much to ignore, so people end up spending billions of dollars each year on products that just don’t work. Of course, the rational or left side of our brain knows the only true way to lose weight and keep it off is with diet and exercise, but that takes time, and we want immediate results/gratification.
This exact thing happens in investing when mutual fund companies entice you with their top-performing funds over the past one-, three-, and five-year periods. Although they have a disclaimer that says, “Past performance is no guarantee of future results,” they know these exceptional returns appeal to the right side of your brain that will jump at the chance of making those same great returns. Come to think of it, I don’t remember many mutual fund companies advertising their poor performance and telling you that “our investment returns will turn around in the future, so invest now.”
Bottom line, if you’ve fallen victim to chasing after investment returns and lost money in the process, don’t make another mistake by swearing off investing and putting all you money in cash. Take this as an opportunity to learn from your mistakes. You paid a great price for this lesson, so you might as well take something from this bad experience so you don’t repeat it again.