Chasing Our Own Tails

I have an Australian Shepherd who is smart as a whip.  I can teach her just about any command in a few hours.  But if I hold her tail up and wave it in her face she starts to spin like a fool until she catches it in her mouth.  Then she realizes that she just caught…herself.   Humans are much smarter than my dog (presumably), but fall victim to the same sorts of deluded thinking at times.

You see, there’s a weird thing that happens year in and year out in mutual fund flows.  We chase our own tails, catch that tail, realize it hasn’t done us any good and then we do it again!  I bring this up after having read this piece on Morningstar (via Jason Zweig):

“As Morningstar’s vice president of research John Rekenthaler has pointed out, people actually tend to select good funds. But their timing in moving among asset classes tends to stink. We saw massive inflows to intermediate-bond funds in 2012 just before one of their worst years in the past 40 years. It’s sort of like the way we saw huge inflows to equity funds in 2000 or huge redemptions in 2009–too much rearview-mirror driving.”

The problem here is multifaceted.  We’re choosing funds based on past performance because, well, there’s not much else to go on.  And for a lot of us the fund options are limited (such as most of our dreadful 401K options) or we just don’t know any better.  But one thing we have to be wary of is this chase for past performance.  It’s not only a nasty case of recency bias, but we know, for a fact, that past winners tend to be future losers.  Even worse, this data shows that we’re timing fund flows based on very short-term performance.

The bottom line: if you’re choosing your funds based on last year’s performance you’re doing it wrong.