Performance Chasing and Outcome Bias
“Money flows into most funds after a good performance and goes out when bad performance follows.” (John Bogle)
We have all seen the wording discretely appended to mutual fund marketing stating that ‘past performance is no guide to future results’. Despite the ubiquity of this message, we struggle to heed its warning. This leads to the damaging behaviour of performance chasing, where we sell our holdings in laggard fund managers and reinvest in recent winners.
The tendency of mutual fund returns to experience mean reversion shows that our propensity to sell strugglers and buy recent winners is not just pointless; it is often the exact opposite of what we should be doing.
This damaging behaviour is driven by outcome bias. Attempting to mitigate outcome bias and prevent performance chasing behaviour means overriding our instincts and also having a willingness to fail unconventionally. Neither of these is simple, but that does not mean there is nothing we can do.
How Can We Prevent Performance Chasing?
Outcome bias cannot be switched off. Whilst awareness is a starting point, it is evident from our continued performance chasing behaviour that it alone is insufficient. We need to make clear and focused interventions to change our behaviour:
Stop Using Performance Screens: Mutual fund performance screens are ubiquitous across the investment industry. Everyone uses some form of historic performance screen to rank funds. Outcome bias and the performance chasing behaviour that follows are difficult enough to avoid even if you are not actively employing tools that encourage it. So, it is best avoided.
Create decision rules: A simple step to avoid performance chasing behaviour is to create fixed decision rules that strictly prohibit it. On average, it should be an effective means of avoiding the cost of purchasing active managers with a high potential for severe mean reversion.
Go Passive: The best behavioural interventions are the simple ones. Anything that requires behavioural discipline or continued effort raises the prospect of failure. Given this, what is the best way to avoid performance chasing in active mutual funds? We can restrict ourselves to buying only passive market trackers.
Specify the activity in which you believe skill exists: When investing with an active manager, we are taking the view that the underlying manager has some form of skill. We tend, however, to be very vague about what we mean by this.
Extend your time horizons: Our susceptibility to outcome bias is greatly influenced by the time horizons involved. If we assess investment performance over one day it can be considered to be pure luck, but as we extend the period skill can exert more of an influence.
Performance chasing behaviour is, of course, not isolated to our selection of active fund managers. It is also not entirely driven by outcome bias. This is not to say that outcomes do not matter. Of course, all investors are seeking better long-term results for their clients. If we want to invest in active managers, we need to think far more about decision quality and process, and far less about yesterday’s performance.
Source: Why Do We Chase Past Performance and What Can We Do About It? By Joe Wiggins
Asset Multiplier Comments:
- Selecting funds based on past performance is like driving a car by looking in the rear-view mirror. There’s very little correlation between past performance and future returns.
- The best way to overcome outcome bias is to focus on passive index-linked funds, which remove the variability of performance chasing.
- If investing in actively managed funds focus on investment thesis and stock selection process rather than past performance.
Disclaimer: “The views expressed are for information purposes only. The information provided herein should not be considered as investment advice or research recommendation. The users should rely on their own research and analysis and should consult their own investment advisors to determine the merit, risks, and suitability of the information provided.”