Normally when we talk about the perils of performance chasing, we are referring to investors buying into asset classes that have done well in the recent past and avoiding those that haven’t fared as well.
Right now, for example, investors want to own US large cap stocks because the S&P 500 is up 13.74 percent over the five years ending Oct. 5, 2015 and want to avoid emerging market stocks because the MSCI EAFE EM index of emerging markets stocks is down -4.32 percent per year over the same period.
Investors tend to fall prey to the ‘recency’ effect, where investors tend to assume that what’s happened recently will continue on indefinitely into the future (this is also called an ‘availability bias’).
While momentum can cause trends to continue longer than the fundamentals may justify, ultimately the momentum stops in what is called a ‘reversal.’
Right now, emerging market stocks are much cheaper than the S&P 500 and in theory, at some point, investors will decide that these stocks are too good a deal to pass up and the current trend will reverse. (This article briefs expected returns for various equity asset classes, but market conditions have changed some since then).
A few days ago, I came across some research conducted by Richard Thaler in the mid-1980s that shows the same effect within individual stocks (the data has been updated through 2013 and still holds).
Thaler is a pioneering behavioral economist who doesn’t believe that investors are logical like Gene Fama and those in the efficient market camp. Thaler believes that humans are indeed imperfect and are subject to all kinds of behavioral biases and conducts research to demonstrate the various biases.
Thaler wrote a well-known paper that sorted stocks based on their performance over the previous five years. They found that the stocks that had performed the worst during the selection period had the best performance in the subsequent five years. And, the opposite was true in that the best performing stocks in the selection period had the worst subsequent five years.
Doesn’t that sound familiar? You buy a stock or a fund because it’s doing so well and wouldn’t you know it, as soon as you buy it, it underperforms. Of course, that’s never happened to me…
Thaler concluded that investors are ‘over-reacting’ to recent performance and the availability of the recent price information that weighted too heavily in the mind of the investor.
But another explanation exists: the losers tended to be value stocks. Being a loser means that people aren’t willing to pay a high valuation and it’s probably a signal that something is wrong in your business.
The winners portfolio is made up of the hot stocks that can do no wrong until they start to miss growth and earnings estimates. Some people refer to reversals as a poor man’s value technique.
I happen to think that this ties in nicely with asset class performance chasing as well, and emerging market stocks are the perfect story: they’ve got real problems, they have cheap valuations and definitely fall into the losers category.
Now who wants to buy them? Nobody that I know, which is why we hold them in a constant weight in a portfolio, which forces us to buy more when they decline in value versus the other asset classes, a process known as rebalancing.
Disciplined processes force you to do the things that work over the long run that your emotions tell you to avoid.