Chasing winners means buying securities with good recent performance. If some stock price rose of late, you might believe demand for their products will continue to rise. If a mutual fund has outperformed its peers, you might conclude it has more adept managers.
But past is not prologue. Advertisements for investment firms that highlight performance must include the caveat that past performance is not indicative of future results. The law requiring this disclaimer was written because the disclaimer is true: past performance of a security provides zero clues on what will happen in the future.
In fact, winners and losers often switch places. In a recent study, Morningstar investigated relative returns of mutual funds. Within each investment category, funds were ranked according to performance each calendar year and split into two groups, top half and bottom half. Over time, Morningstar found funds in the bottom half one year were more likely to be in the top half the following year than those which had been in top half the first year. Those in the top half any given year were more likely to be in the bottom half the next year.
Further proof of the futility of choosing recent winners comes from the Standard & Poor’s Persistence Scorecard, a survey in which all managed generic U.S. stock funds are tracked. First, S&P identifies the top 50% of funds in terms of performance for the 12 month period ending March 31, 2010. Moving forward, S&P determines the percentage of these funds still in the top half for the following 12 months (ending March 31, 2011), the next 12 months (ending March 31, 2012) and onward. In the graph, each cluster of bars shows the percentage of ‘top’ funds still in the top half 1, 2, 3, and 4 years later. If choosing winners is helpful, more (much more) than 50% of these top funds should still be in the top half year 1, more than 50% of those remaining (ergo more than 50% of 50%, or 25%) should be in the top year 2, etc.
In the featured graph, the first bar in each cluster marks a 75% theoretical success (outperformance) rate. The second bar of each cluster marks the 50% success rate which would indicate irrelevance of picking winners. The 4 bars to the right in each cluster show, respectively, actual results of all top funds, top large-cap funds, top mid-cap funds and top small-cap funds. The results are actually worse than random. Only 42.8% of the “best” funds were in the top half year 1, only 19.9% of the original group made the top half in year 2 (25% would have indicated randomness). Just 7.9% were atop year 3 (versus 12.5% for mere irrelevance) and 4.5% remained in the top half in year 4 (with 6.25% the random indicator). Not only did picking winners not help; it hurt.
Analytically, things change; hype calms down, new becomes old, and mistakes get corrected. If a company is ridiculously profitable, new firms enter their line of work. If a company struggles but survives, its stock price will probably reach a level from where it can grow like any other.
Chasing winners is pointless. But chasing losers is equally fruitless. Win or lose, past behaviors do not indicate future results.
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