When you buy a mutual fund based on its recent performance, you could be succumbing to the "recency effect."
It's a "cognitive defect" from which most people suffer, says Josh Brown, chief executive of New York-based Ritholtz Wealth Management. "People extrapolate what just happened into more of the same." Or put another way, if stocks have consistently risen year after year, people expect they will continue to do so indefinitely.That's the tendency when making a decision to give recent events more weight than things further in the past.
Recency bias helps fuel trends by telling people to pile into holdings that are doing well and cash out of investments that are doing poorly. The problem is, sooner or later trends reverse.
Say you jumped into U.S. stocks in January based on last year's performance. Mutual funds focused on U.S. equities gained an average of 34.2% in 2013, but tacked on less than 1% in the first three months of this year, according to Morningstar Inc. Meanwhile, some of the worst-performing asset classes of 2013 have outperformed this year. Funds invested in long-term government bonds lost 13.3% in 2013, but rose 7.4% in the first quarter.
"It's very rare for the same asset class to be at the top of two consecutive years' performance charts," says Mr. Brown. "It's almost always a different sector."