In a two-part series for Canada’s Globe and Mail, Validea CEO John Reese shows how chasing hot sectors or regions can lead to big trouble for stock investors.
In Part I of the article, Reese looks at several back-tested portfolios to see how investors who tried to jump on stocks in hot-performing regions would have fared over the past three decades. The answer: not good.
“Why does chasing the best performing markets end so badly for most?” Reese asks. “The answer lies largely in our brains. Studies have shown that one of the behavioural biases that dogs investors is ‘recency bias,’ the tendency to believe that recent events will repeat themselves in the future. So, by the time an area of the market is hot enough for you to take notice, the odds are that thousands of others have probably noticed, too. And by the time you get on the bandwagon, whatever country or sector or size/style of stock you’re buying may well be overheated, and positioned to underperform going forward.”
Reese acknowledges that many investors might want to focus on hot-performing areas because of their strong recent growth, and/or expectations for strong future growth. That may sound reasonable, but, he says, it’s an approach that has some big flaws. Reese shows how forecasters often miss the mark — sometimes by a lot — when it comes to predicting economic growth. And, he looks at studies that show strong economic growth may actually lead to stock market underperformance.