Avoid the Wealth Destroying Habit of Trend Chasing
How recency bias and trend chasing impact your finances
One of the least understood concepts in investing is that what happened in the past has zero influence on what will happen in the future.
Most people reading this are probably nodding their heads in agreement. But the reality is that most people look to the past—and often the very recent past—to determine how to invest their money.
In this article, I’ll discuss how recency bias leads to trend-chasing, which is one of the most common and damaging mistakes investors make.
What is recency bias?
Recency bias is when we think that what happened in the recent past will continue happening in the future.
People are hardwired to look for patterns to make sense of our chaotic world, and we tend to (wrongly) believe that what is happening now or what just happened is the beginning of a trend that will continue playing out.
But often, what happened recently is not the beginning of a continuing trend but was a random event that has little to no impact on what will happen next.
This is especially true when it comes to investing, where today's hot investment often fizzles out in the future.
You pay for last year’s winner and receive tomorrow’s loser
“Past returns are not indicative of future results.”
That’s a legally required disclosure that investment firms must include when selling their investment products and services. But most of their marketing materials focus on how seemingly impressive their past returns have been—especially their recent returns.
Investment firms emphasize recent returns because it’s an effective marketing strategy. A 2000 paper found that nearly 40% of new money invested in mutual funds went to the funds that performed in the 90th percentile the year before.
But, the funds that outperformed last year often underperform this year.
A 2020 paper found no evidence that investment funds in the top 10% of returns in the prior year continue to outperform in the future. To quote the researchers, “If anything, over the past two decades, you seem to do a little bit worse if you chase past returns on mutual funds.”
Trend chasing is a natural consequence of recency bias. You overweight the recent returns of a particular investment because you think the trend will continue—but the more likely outcome is that you bought at the peak.