It’s not often that I get the chance to combine music, a 3-year-old, and investing in a cogent thought, but as fate would have it, inspiration hit as I was driving my son to school. Somehow my 3-year-old son has become a huge country music fan (I’m not exactly sure how it happened since I never listened to country music in my life before the last three years) and loves to call out the names of songs and (attempt to) sing along. Naturally, “Roller Coaster” by Luke Bryan came on as we were driving to school. When the song got to the chorus “. . . Now she’s got me twisted, like an old beach roller coaster,” my inquisitive little man asked, “Daddy, what’s a roller coaster”?

Now most of us at some point in time have undoubtedly tried to explain something to a 3-year-old. It isn’t easy . . . usually it either generates more questions or a blank stare. But sometimes you hit the nail on the head and they’re satisfied (and hopefully have learned something). So my rapid response was, “Kyle, a roller coaster is like a train that goes really fast up and down.” Naturally, his follow-up question was, “Daddy, do they go to visit Thomas in Sodor?” And my response: “No bud, they actually end up right where they started. They go in a big circle with lots of bumps along the way.”

And then it dawned on me that investment performance can be exactly like a roller coaster—yes, there is the overused analogy of the peaks and troughs of the markets; but what intrigued me was the idea that after going through it all you could actually end up right where you started (or even worse) if you act or react poorly along the way.

My spark was a recent Journal of Portfolio Management article by Amit Goyal, Antti Ilmanen, and David Kabiller titled “Bad Habits and Good Practices.” The authors revisit (among other things) the issue of return-chasing, whereby investors tend to buy winners (after they’ve won) and sell losers (after they’ve lost). The authors add data and perspective to an oft-referenced article from 2008, also by Amit Goyal (this time with Sunil Wahal), which showed that institutional investment committees tend to hire and fire managers based on performance and that the net result of those decisions amounted to pro-cyclical return-chasing (and therefore underperformance—see chart below).

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Adding speed to the roller coaster, Vanguard Investment Strategy Group performed a simulated analysis of similar hire/fire behavior using the universe of active funds. The results were directionally similar to the Goyal/Wahal findings in that performance-chasing led to lower returns. The key difference between the chart above and the chart below is the magnitude of underperformance versus those who just let their funds ride out those performance peaks and troughs. In the first chart, the difference between new and old funds after the change was approximately 1% over the next three years. In the second chart, the difference averaged 2.8% between the buy and hold and performance chasing portfolios.

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Source: Vanguard Investment Strategy Group, 2014. Quantifying the impact of chasing fund performance. For a detailed explanation of our methodology for this chart, please see the table at the beginning of the Notes section below. Past performance is not a guarantee of future results.

It’s that underperformance, driven by the pro-cyclical return-chasing of investors and investment committees, which is so eye-opening. Clearly it’s not difficult to see how changing a client’s portfolio, even if it’s only every few years, can lead to them always playing catch-up and ending up (figuratively) right back at the start. In fact, this is a primary reason that when Vanguard’s portfolio review department evaluates a manager of one of our active funds, or when our Strategic Asset Allocation committee reviews our strategic model portfolios, we take the view that unless a systemic shift has occurred in a portfolio, manager or strategy, changes shouldn’t be made. While short- or intermediate-term performance deviations, in particular, are evaluated and understood, they aren’t acted upon. So whatever you do, the next time you sit down for a review of your client’s portfolio, resist the urge to make changes based on performance reasons alone.

So it turns out that while a roller coaster gets you back to the starting point, the returns roller coaster is more analogous to one where you lose your hat and sunglasses (and wallet) along the way!

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Note:

All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

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