Chasing past performance

When gold rallies, money pours into gold funds. When equities rally, money pours into equity funds. This pattern — buying whatever performed best last year — is chasing past performance, and it rests on an assumption the workbook flatly rejects.

The underlying belief is that what did well last year will keep doing well this year. Most asset classes actually move in cycles of growth and decline, and eventually revert toward their long-run average. Chasing last year's winner, the workbook says, is like driving a car by looking only in the rear-view mirror — it works fine until the road ahead is different from the road behind, and then it does not work at all.

The mechanism is simple and self-reinforcing: an asset class rises, media coverage and word-of-mouth highlight the gain, more money flows in chasing that same gain, prices rise further on the extra demand — and then, when the cycle turns, the same investors who bought at the top are the ones left holding the loss.

The workbook prescribes a structural, not a willpower-based, fix: a pre-decided asset allocation policy with upper limits for each asset class. If gold is capped at, say, 10% of the portfolio by policy, an investor cannot chase a gold rally into an outsized position no matter how tempting the recent return looks. The same logic extends within an asset class — a maximum exposure limit for any single security stops an investor overloading on one recent winner inside the equity sleeve as well.

Illustrative figures.

Over three consecutive years, an investor without a fixed allocation policy chases returns:

Each move was made after the gain had already happened, and each asset class then underperformed in the following year — the classic pattern of buying high because of what already happened, not because of what is likely to happen next.

An investor instead following a pre-decided policy — say, 50% equity, 40% debt, 10% gold, rebalanced back to those weights once a year — would never have chased any single year's winner into an oversized position, and would have automatically trimmed whichever asset class had run up the most.

Chapter 17 (Behavioral Finance in Practice) covers chasing past performance directly after action bias, using the rear-view-mirror analogy and prescribing pre-decided allocation limits as the remedy. Expect a question on what causes this bias (mean reversion being ignored) and on the specific tool the workbook recommends against it — upper limits by asset class and by individual security.

• Most asset classes are cyclical, not persistently trending — the workbook's core objection to performance chasing is that last year's winner has no special claim to being next year's winner too.
• The remedy is structural (a written allocation policy with caps), not just "advise the client to be patient."
• The cap applies at two levels — asset class, and individual security within an asset class — a question may test either.
• This bias often combines with action bias — the urge to act plus the temptation of a recent winner reinforce each other.