Tuesday, September 6, 2022
A favorite (and costly) pastime of investors is to invest in assets that have recently done well. This happens in good times as investors seek better returns, and they happen in bad times as low-yielding investments such as cash are more attractive than money-losing stocks. In other words, investors chase returns.
By investing in what just did well, investors are systematically buying after they witness gains elsewhere and selling after their assets experience loss. Chasing returns can feel very good at the time but comes with a real financial cost. Dalbar, Inc. estimates that equity investors underperformed the S&P 500 by roughly 6% per year over the last 20 years1 due to the timing of buying and selling.
Why We Chase Returns
There are two primary reasons it feels right to buy after we witness gains and sell after experiencing losses:
- We are greatly influenced by what just happened. Whenever we try to project the future, our brains are significantly influenced by what just happened. Good outcomes today implies that things will be good going forward, and vice versa.
- This is exacerbated by the narrative of the day. Our brains love a good story. We seek information to understand. When the market goes up, the narrative is often positive, leading us to feel good about the future. When the market goes down, the narrative is almost always negative, reinforcing a negative outlook.
Normal, But Not Beneficial
It is completely normal to invest in things we expect to go up and avoid assets we expect will go down. In fact, any rational person would do that as part of their investment strategy. But the problem is that markets move quickly and often surprisingly. Narratives are wonderful and can be quite accurate in hindsight. They can even increase our confidence in a certain viewpoint, but narratives offer no predictive ability in future outcomes.
Therefore, I advise you to remain disciplined to your plan and stay the course. Of course, this is not easy; temptations abound that are pleasing to our mind and feelings. But that is why you have me. Together, we can be aware of common investment pitfalls and ensure that all investment decisions are well-thought and in line with your stated objectives.
©2022 The Behavioral Finance Network
- JP Morgan Guide to the Markets. July 2022 edition. Slide 63.