Don't Chase Investments Based on Sizzling Returns

Provided by Russell Investment Group

Changing investment strategies based on the past performance of a particular investment can be a buy-high strategy that could leave you with disappointing investment returns.

Chasing the latest hot mutual fund or stock is an example of "rearview mirror" investing. Typically, rearview mirror investors watch the sizzling returns from a particular investment and buy in, hoping to realize similar returns. But their timing is generally off. Often, the biggest gains have already been realized before the investment gets enough publicity to attract the attention of the rearview mirror investor.

Assume, for example, that a mutual fund with a $20-per-share value rises to $30, earning $10 per share for the early investors. The performance attracts media attention and rearview mirror investors jump in at $30 per share, or higher. Now the fund runs into a slow period and the shares drop to $25 each. The early investors still made a tidy profit. The rearview mirror investors have lost $5 per share, as shown in the following chart.*

Some investors made similar mistakes with emerging-market stocks a few years ago.

Investors who, as part of their diversification strategy, had allocated a portion of their portfolio to foreign stocks enjoyed strong market gains. Predictably, these returns attracted media attention and the rearview mirror investors joined in—just before these markets took a tumble.

While current emerging market returns may be disappointing, they offer some evidence that diversification works and that rearview mirror investing can lead to disappointment. A diversified portfolio is designed to provide a smoother ride for the investor by spreading risk among investment types. By definition this means a diversified portfolio could include, at any one time, some of the hottest and some of the coolest investment options.

Currently, emerging market returns are disappointing to many, and rearview mirror investors have moved on to other opportunities. Long-term, diversified investors don't chase the latest trend, however, and many maintain some foreign-market investment. Diversified investors generally expect that some of the best investments could be part of their portfolios—at the beginning of their cycle, not at the end.

Rearview mirror investing is, by nature, based on past performance. And allocating your assets based on past performance is simply not a good substitute for focusing on your specific investment goals and sticking to a long-term strategy.