What it means
When prices are rising and headlines are cheerful, it feels natural to want a share of the gains. Chasing the market is the habit of moving money into whatever has performed best recently, whether it is a fund, a sector or a fashionable asset, on the assumption that the trend will carry on.
The problem is timing. By the time a rise is obvious to everyone, much of the gain has usually already happened, and the buyer enters at a higher price with less room for further profit.
When prices later fall, fear prompts a sale, which locks in the loss. In a business context the same behaviour appears in treasury, pension and corporate investment decisions.
A company may pile into a hot sector at the peak, or a pension committee may replace a fund that has lagged for two years just before it recovers. Researchers who study investor behaviour often describe a behaviour gap, which is the difference between what an investment returns and what the average investor in it actually earns.
The gap arises because money tends to flow in after strong years and out after weak ones. The cure is a plan that is set in advance.
A written investment policy, a target mix of assets, and regular rebalancing, which means bringing the portfolio back to its target proportions, make decisions rule-based and reduce the pull of headlines. None of this means that strategies should never change.
Reviewing a manager or a sector for sound reasons, such as a change in fees, staff or approach, is healthy, whereas switching because of recent returns alone is the trap.
In practice
Real-world examples.
Example
A technology stock triples in a year and a marketing manager moves her entire savings into it at the peak. The share price then falls by 40% and she sells in a panic. She would have done better with a regular, smaller investment each month.
Example
A pension committee drops a steady bond manager after two weak years and hires last year's top performer. The new manager's style then goes out of favour, and the committee ends up with higher fees and no better results. A written rule that requires a minimum review period would have prevented the switch.
Example
A small business owner puts spare cash into a booming property market because friends are doing the same. When interest rates rise and prices stall, he needs the cash for payroll and has to sell at a loss. A cash reserve kept apart from investments would have avoided the problem.
Formula
Calculation
Behaviour gap = Return of the investment - Return actually earned by the investor
Suppose a fund returns 8% a year for 10 years, while an investor who buys after strong years and sells after weak ones earns 5% a year on average. An initial $100,000 in the fund grows to 100,000 x 1.08 to the power of 10, which is about $215,900. The investor's $100,000 grows to 100,000 x 1.05 to the power of 10, which is about $162,900. The behaviour gap is 8% - 5% = 3% a year, and over 10 years it costs about 215,900 - 162,900 = $53,000.Case study
Seen in the real world.
Lakeshore Interiors is an illustrative, fictional furniture retailer that kept $600,000 of surplus cash in a diversified portfolio. After a strong year for one sector, the owner moved $250,000 into a fund concentrated in that sector.
Within eight months the sector fell by almost a third, and the owner, worried about the lost value, sold the fund at a loss of about $80,000. Soon afterwards the sector began to recover, and the portfolio he had left would have been worth more had he held on.
The company's accountant then helped draft a short investment policy with a target mix, a limit on any single sector and a yearly review date. The illustrative lesson is that rules written in calm conditions protect a business from decisions made in excited or frightened ones.
Watch out
Common mistakes.
- Judging an investment only by last year's return, when past performance does not reliably predict the next period.
- Selling after a fall without considering why it happened, which often turns a temporary loss into a permanent one.
- Believing that a trend must continue because everyone is talking about it, when popularity is often a sign that much of the gain has been made.
Questions
People also ask.
Why do people chase the market?
Fear of missing out and fear of loss are strong emotions, and recent returns are easy to see while the risks of buying after a rise are harder to feel.
How can I avoid chasing the market?
Set a target mix of investments in advance, invest regularly in fixed amounts, and rebalance on a schedule rather than in reaction to the news.
Is it always wrong to follow momentum?
Not always, because some professional strategies use momentum with strict rules and risk limits, but doing it by feel and without rules is the form that tends to disappoint.
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