Investors generally understand the interpretation of annualized investment performance. However, when it comes to making investment decisions, investors tend to place undue importance on recent investment performance.

As a group, investors consistently believe there is information in recent past investment performance that will help them select future outperforming strategies. But emerging research suggests that this is a dangerous strategy and that performance reversion is a common outcome. The 2010 Quantitative Analysis of Investor Behavior observes that the average U.S. equity investor earned 20-year annualized returns of roughly 3% versus the equity markets at near 8%. The performance gap is attributable to a short average holding period of just over three years for an equity mutual fund. Simply put, investors buy funds with strong recent performance and sell following recent underperformance with the result being an investment experience well below the market.

The Selection and Termination of Investment Management Firms by Plan Sponsors study looked at institutional markets by examining both pre- and post-manager change investment performance of more than 8,700 changes made by institutional investors. Conclusions indicated that based on three-year trailing and forward performance status quo, making no change would have outperformed changing managers.

Another study—Absence of Value: An Analysis of Investment Decisions by Institutional Plan Sponsors—analyzed pooled funds by comparing funds that have experienced strong contributions to those in withdrawal. Subsequent performance mean reverted with outflow funds outperforming strong sellers in the next one-, three- and five-year periods. Within the Canadian marketplace, a ranking of Canadian pooled funds’ performance for a four-year period ending 2006 in order can be compared with the performance of the next four years. The outcome indicates a random subsequent period performance with just two of the top 10 performers delivering above-average performance and five of the bottom 10 outperforming the average.

These studies suggest that the odds of successful switching based on recent performance are stacked against success and that the costs of this are largely unconsidered. Successful investing should continue to recognize that market cycles are much longer than typical four- or five-year periods. Engaging investment management firms with established succession planning, a strong compliance culture and a well-defined process can help minimize the need for changes. Also, building an understanding of performance relative to the market and investment style can help rationalize short-term performance. Regular meetings with managers can help investors understand the strategy and remain vigilant to a strategy capitulation whereby managers may erode value by chasing a theme in the market.

Alan Daxner is executive vice-president with McLean Budden.

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Copyright © 2019 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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