The Siren Song of Performance: Why We Chase Last Year’s Best Fund—and Regret It
Every January, financial publications proudly announce the previous year’s top-performing mutual funds and ETFs. Like moths to a flame, investors swarm toward these “winners,” pouring billions into strategies that just demonstrated extraordinary success. Yet, consistently, this behavior leads to disappointment. This isn’t just bad luck—it’s a predictable pattern rooted in the psychology of recency bias.
The Allure of the Recent Past
Imagine two funds:
- Fund A: Returned 45% last year, featured prominently in financial media
- Fund B: Returned 8% last year, barely mentioned
For most investors, the choice seems obvious. Why settle for mediocre returns when spectacular ones are available? This intuitive preference for what just happened represents recency bias—the cognitive tendency to overweight recent experiences while underweighting historical data.
In investing, this manifests as performance chasing: moving capital into assets, sectors, or strategies that have recently outperformed, often near their peak.
The Behavioral Psychology Behind Performance Chasing
Several interconnected cognitive biases drive this counterproductive behavior:
1. Availability Heuristic
We judge the probability of future events by how easily examples come to mind. Recent dramatic performance is cognitively “available,” making future similar performance feel more likely than it actually is.
2. Narrative Fallacy
We crave coherent stories. “This fund manager is a genius” or “this strategy works in today’s market” provides a satisfying explanation for past performance, even when randomness played a significant role.
3. Confirmation Bias
Once we notice a top-performing fund, we seek information that confirms our decision to invest while dismissing warnings about mean reversion or sustainability.
4. Herd Mentality
Seeing others invest in a “winning” fund validates our decision socially. If everyone’s doing it, how wrong could it be? This creates self-reinforcing flows that often inflate bubbles.
The Empirical Evidence: Performance Chasing Destroys Value
Research consistently demonstrates the costly consequences of recency bias:
A seminal Morningstar study found that while funds themselves delivered reasonable returns, the average investor in those funds earned significantly less due to poorly timed entries and exits. Investors consistently bought after strong performance and sold after disappointing returns—the exact opposite of a profitable strategy.
Consider technology funds in 1999, cryptocurrency in 2017, or ARK Innovation ETF in 2020. Each attracted massive inflows after spectacular returns, only to deliver devastating losses to latecomers.
Why Last Year’s Winner Often Becomes Next Year’s Loser
Several structural factors explain this pattern of reversal:
Mean Reversion
Extreme performance in financial markets tends to revert toward the mean. A fund that returned 45% in a year likely benefited from:
- Concentration in a hot sector
- Favorable market conditions unlikely to persist
- Taking above-average risk that eventually materializes
Size as an Anchor
Successful funds attract enormous inflows, making them less agile. A $50 million fund can nimbly invest in small-cap opportunities; a $5 billion fund cannot. The very act of performance chasing often destroys the conditions that created the outperformance.
Strategy Saturation
When a particular investment approach works exceptionally well, others copy it. As capital floods into similar strategies, opportunities diminish and correlations increase, reducing future returns.
Breaking the Cycle: Practical Strategies
Overcoming recency bias requires deliberate effort:
1. Implement a Cooling-Off Period
Establish a rule: never invest in any fund that has appeared on a “top performers” list within the last 30 days. This creates space between emotional reaction and investment decision.
2. Focus on Process Over Outcomes
Evaluate investment strategies based on their underlying logic and consistency, not recent returns. Ask: “Why did this work?” not just “How much did it make?”
3. Practice Contrarian Rebalancing
Systematically sell portions of outperforming assets and buy underperforming ones within your portfolio. This forces you to act against recency bias.
4. Lengthen Your Time Horizon
Evaluate performance over full market cycles (5-10 years), not calendar years. This reduces the psychological impact of recent performance.
5. Automate Your Investments
Use systematic contributions to predetermined allocations. Automation creates a barrier between emotional responses and portfolio changes.
6. Embrace “Boring” Consistency
Seek funds with steady average returns over long periods rather than spectacular short-term results. Consistency is more valuable—and more repeatable—than brilliance.
The Long View: Beyond Recency
Successful investing isn’t about capturing yesterday’s returns—it’s about positioning for tomorrow’s opportunities. This requires looking beyond what just happened to understand what might happen next.
Remember that financial media and fund companies have incentives to highlight recent winners. Their goals (attracting viewers or assets) don’t always align with your goal (building sustainable wealth).
The most counterintuitive but essential insight: sometimes the best future investments are those that have recently performed poorly. They’re out of favor, undervalued, and unloved—precisely the conditions that create opportunity.
“The intelligent investor is a realist who sells to optimists and buys from pessimists.” — Benjamin Graham
Final Thoughts
Recency bias is powerful precisely because it feels so logical. If something worked yesterday, why wouldn’t it work tomorrow? But financial markets operate on different principles than our intuitive psychology.
By recognizing this bias in ourselves, implementing systematic defenses against it, and focusing on long-term processes rather than short-term outcomes, we can avoid the costly cycle of chasing yesterday’s winners.
The next time you see a list of top-performing funds, remember: that’s not an investment opportunity—it’s a psychological test. Pass it by looking the other way.
