My seven-year-old son has recently discovered the joy of whoopie cushions. If you’re wondering, they haven’t changed much in the last thirty years—they’re still red, still have a short lifespan, and still offer a few laughs before they start to get on your nerves.

He got his first one as a party favor recently, and of course, he loved it—until it sprung a leak, as they all eventually do. Naturally, he asked me to get him a new one, and I figured, why not? It’s practically a childhood rite of passage.

So, I hopped on Amazon to order a replacement, and that’s where I fell into the whoopie cushion rabbit hole. The first one had a 3.5-star rating with a ton of reviews. The second had a 4-star rating but with fewer reviews. Which one was the better buy? Do I trust the quantity of reviews or the higher rating? Suddenly, I was overthinking this minor decision like it was a life-or-death situation. One wrong choice, and my son’s childhood might be ruined forever…

How to Make Good Decisions

I’m sure you’ve been there too—maybe while searching through Yelp or Open Table reviews before picking a restaurant. These reviews help guide us to make good decisions because, typically, a highly-rated experience tends to deliver on its promise.

These reviews help us make an informed buying decision because positive reviews are often highly predictive of the experience we can expect ourselves. That is, if you choose a highly-rated restaurant, you are likely to have a good dining experience. 

The same logic often applies when we think about big decisions, like choosing a college. Top colleges are consistently at the top, year after year, and past reviews usually predict future success.

 It’s easy to see how this mindset creeps into our investment decisions too. But is that always a good thing?1

The Temptation of Chasing Past Performance

One of the biggest traps investors face is chasing past performance. Many investors, including professionals, can’t help themselves when it comes to chasing yesterday’s winners and avoiding yesterday’s losers. 

There’s a logic to this—if something worked well before, it should work well again, right? But let’s dig a bit deeper to see why this approach often fails and what we can do to avoid it.

A quick look at annual returns across different asset classes reveals something sobering: last year’s results don’t predict next year’s. The outcomes are more random than we’d like to admit. 

But does that stop investors from chasing after last year’s top performers? Not really. As the chart below shows, investors tend to pour more money into last year’s winners while pulling cash from the underperformers.

Now, you might think that just because asset class returns in one year are not predictive of how they’ll do the following year doesn’t mean that investment managers within each asset class that outperform in a given year can’t do it again the following year. And you’d be right – random asset class returns don’t mean chasing an outperforming manager’s performance is a bad idea in and of itself. But unfortunately, the following chart puts a nail in that coffin too. 

The chart above tracks how funds performed over three years after ranking in the top quarter of their category. The result? A fund that was a top performer in 2019 was just as likely to end up in the bottom quarter over the next three years as it was to stay at the top. There’s no real predictive power in a fund’s past success. What works for picking a whoopie cushion or a restaurant doesn’t translate to picking investment funds.

Trees Don’t Grow to the Sky: Neither Do Asset Classes

Chasing past performance is also flawed from an economic standpoint. Here’s the math: strong past performance leads to higher valuations, making an investment more expensive and less appealing moving forward. On the flip side, poor performance makes an investment cheaper and potentially more attractive in the future.

An awesome product review on Amazon doesn’t impact the next person’s experience, but in investing, it does. A good return last year makes it less likely that an investor will do as well this year. 

How to Stop Chasing Past Performance

The first step in solving any problem is recognizing that the problem exists. Now that we’ve done that, here are three more tips to help you kick the habit of chasing past performance:

1. Cut yourself some slack. Remember, even pros are tempted to chase performance. Changing a mindset that works in other areas of life is hard. 

2. Focus on what you can control. Just like candy, what’s tempting is rarely good for you. Chasing past performance and trying to time the market might seem like smart moves, but they’re not effective for long-term success. Instead, focus on your savings rate and your time IN the market with a long-term approach to give yourself a leg up on financial success.

3. Make a financial plan. When I don’t pack lunch for work, my diet goes down the tubes. You’ve heard it before – if you fail to plan, plan to fail. A solid financial plan can help you stay on course and resist the urge to chase past performance when the market temperatures change. 

Castle Quote: “In the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, perception often swings from “flawless” to “hopeless.” The pendulum careens from one extreme to the other, spending almost no time at “the happy medium” and rather little in the range of reasonableness.” – Howard Marks

Source: https://advisors.vanguard.com/content/dam/fas/pdfs/FAIARCMM.pdf