What is meant by “chasing winners”?
Chasing winners means buying securities with good recent performance. If a company’s stock price rose of late, you might believe demand for its products will continue to rise. If a mutual fund has outperformed its peers, you might conclude it has more adept managers.
Why you should avoid chasing winners
Past is not prologue
Advertisements for investment firms include the caveat “past performance is not indicative of future results” or a similar phrase whenever citing returns. The law requiring this disclaimer exists because the disclaimer is true: past performance of a security provides zero clues on what will happen in the future.
Winners and losers often switch
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.
To further demonstrate the futility of choosing recent winners, Figure 37-1 graphs data from Standard & Poor’s Persistence Scorecard, a survey in which all managed generic U.S. stock funds are tracked. First, S&P identified the top 50% of funds in terms of performance for the 12-month period ending March 31, 2010. Moving forward, S&P determined 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 one, two, three, and four years later. If choosing winners is helpful, way more than 50% of these top funds should still be in the top half year one. Going forward more than 50% of those remaining (ergo more than 50% of 50%, or 25%) should be in the top half year two, etc.
In the graph, the first bar in each cluster marks a 75% theoretical success rate, indicating outperformance. The second bar of each cluster marks the 50% success rate which would indicate irrelevance of picking winners. The four 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 as of the beginning of the study were in the top half as of the end of year one. Only 19.9% of the original group made the top half in year two; 25% would have indicated randomness. Just 7.9% were atop year three; versus 12.5% for mere irrelevance. 4.5% remained in the top half in year four, with 6.25% representing 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.
What you should do instead
Chasing winners is pointless. But don’t infer a false conclusion: chasing losers is equally pointless. Win or lose, past behaviors do not indicate future results. Many bad firms fail, and many funds do poorly over long spells, especially those with high fees that damage returns year after year.
Indeed, ‘winning’ in investments is a relative term. Over 20-year spans, index funds have outpaced about 90% of the funds actively managed by professional money managers. That is a pretty high winning percentage. If you’ve banked on winners in the past, consider index funds for the future. Click here for an effective path.
* Data source:
S&P Dow Jones Indices LLC; S&P Persistence Scorecard, June 2014