Behavioural Finance
Chasing Past Returns
Why investors pile into funds and assets after they have done well, why past performance is a poor guide, and how recency bias shapes investment flows.
When a mutual fund or sector has a great year, money floods in. When it has a bad year, investors pull out. This pattern of chasing past returns is one of the most consistent findings in behavioural finance.
Recency and extrapolation
- Recency bias: people give too much weight to recent events.
- Extrapolation: they assume recent trends will continue.
If a fund returned 40 percent last year, investors expect more of the same.
The evidence
Studies of mutual fund flows in the US and other countries show that money flows strongly into funds with high recent returns. Yet research also shows that top-performing funds rarely stay at the top. Studies of US funds, such as S&P’s persistence reports, find that few top-quartile funds remain in the top quartile over the next several years.
Why past performance fades
- Luck plays a large role in short-term returns.
- Strategies that worked in one market environment may not work in the next.
- Popular assets become expensive, lowering future returns.
- Large inflows can make funds harder to manage.
Sector fads
Chasing returns also appears in sectors: technology in 1999, real estate before 2008, small-cap stocks after big rallies. In India, flows into thematic and small-cap funds surged after strong returns, prompting SEBI to ask fund houses to run stress tests on small-cap funds in 2024.
The cost
Investors who buy after big rises and sell after falls earn less than the funds themselves, because their money is in the fund at the wrong times.
Better habits
- Choose funds based on costs, strategy and long-term consistency, not last year’s return.
- Stick to an asset allocation plan.
- Remember the standard warning: past performance is not a guarantee of future returns.
A small-cap fund returns 60 percent in one year and tops the rankings. Thousands of new investors join. The next year, small caps fall, and the fund loses 25 percent. Many of the new investors sell at a loss, never having enjoyed the earlier gains.
Top performers rarely stay on top. Costs and consistency matter more than recent returns.
- Investors pile into funds and sectors after strong recent returns.
- Recency bias and extrapolation drive this behaviour.
- Few top funds stay at the top over time.
- Choosing by costs, strategy and long-term consistency is wiser.
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