Performance Chasing Yields High Returns But Risks Remain

Consumer Staples

18 days agoPWG Publications

Introduction to Performance Chasing

In the world of investing, strategies abound, but few have captured as much attention as performance chasing. This approach, where investors select funds based on their past performance, has yielded impressive returns over the past decade. However, it comes with significant risks, including overvaluation and potential downturns in market trends. Despite these challenges, performance chasing has emerged as a top performer among common investment strategies. To understand the dynamics and implications of this approach, let's delve into its mechanics, benefits, and pitfalls.

Understanding Performance Chasing

Performance chasing involves shifting investments annually to the sectors or funds that have performed best over the preceding year. This strategy leverages momentum, betting on continued success in high-performing areas. Over the past decade, it has been particularly effective in sectors like technology and healthcare, which have experienced substantial growth and become crowded trades[1][3].

Key Points of Performance Chasing:

High Returns: Performance chasing has delivered returns of up to 154.7% over ten years, outpacing other strategies[1][3].
Risk Involvement: The strategy carries risks due to overvaluation and dependence on trends continuing[3].
Sector Focus: Investors have invested in tech, healthcare, India, China, and commodities funds[1].

Performance Chasing vs. Other Strategies

AJ Bell's research contrasts performance chasing with several other investment strategies:

Egg Spreading (Diversification): Distributes investments across multiple sectors to manage risk[1][3].
Bargain Hunting: Invests in underperforming sectors, hoping for a rebound[1][3].
Herd Investing: Follows popular trends and sectors[3].
Contrarian Investing: Invests in less popular sectors in anticipation of future growth[3].

Comparison of Investment Strategies

| Strategy | Description | 10-Year Return | |-----------------------|----------------------------------------------|-----------------| | Performance Chasing | Invests in previous year's best-performing sector | 154.7% | | Egg Spreading | Diversifies across major equity sectors | Lower than global tracker funds | | Bargain Hunting | Invests in previous year's worst-performing sector| 62.7% | | Herd Investing | Follows the most popular investment sectors | Similar to contrarian investing | | Contrarian Investing | Invests in less popular sectors | Similar to herd investing |

Risks Associated with Performance Chasing

Despite its success, performance chasing comes with significant risks:

Overvaluation: Sectors that have performed well often become overvalued, making them vulnerable to downturns[3].
Trend Reversals: A reversal in market trends could be painful for undiversified performance chasers[1][3].
High Volatility: Performance chasing typically involves investing in specialist sectors, which may exhibit high volatility[1].

The Cost of Performance Chasing

Research by Vanguard and Harbor Capital highlights the potential costs:

Vanguard Study: Found that performance chasing reduces average returns by over 2% per year[2].
Harbor Capital Insights: Revealed that performance chasing costs investors about 16% of their returns on a rolling 60-month basis, particularly during high volatility[4].

Alternatives to Performance Chasing

For investors looking for less risky strategies:

Passive Investing (Global Tracker Funds): Offers steady returns with broad market exposure, often outperforming diversified strategies over time[1][3].
Long-Term Investing Strategies: Based on sound financial analysis rather than past performance, these approaches tend to be more stable and less susceptible to market whims[2][5].

Benefits of Passive Investing

Stability: Offers consistent returns across various market conditions.
Cost Efficiency: Typically involves lower fees compared to actively managed funds.
Diversification: Spreads risk by investing across a broad range of assets.

Conclusion

While performance chasing has yielded strong returns, it's crucial for investors to understand the risks involved. Diversification through passive strategies can provide a more stable alternative. As the investment landscape evolves, staying informed and adapting strategies to the market's dynamic environment will be key to success.

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