Mutual Fund performance: Why investors should not fall prey to recency bias

We analysed the performance of all equity mutual fund schemes for consecutive three year periods and ranked them.

By Umang Thakker

English all-rounder Ben Stokes played a major role in England’s win over New Zealand in the World Cup final at Lord’s, scoring 84 and taking the game into a super over, where they clinched a remarkable victory. He followed it up with a breathtaking 135 not-out in the 3rd Ashes test at Headingley, taking England to an improbable one-wicket victory in August 2019.

More than 1,000 England cricket fans were surveyed by the Professional Cricketers’ Association and NatWest in honour of the 50th anniversary of the Professional Cricketers Association Awards in October 2019 where they were asked to rank greatest performances in the last 50 years of England Cricket. Little wonder that both of Stokes’ performances made it to the top 50 list.

The above outcome is a clear imprint of recency bias.

Mutual fund performance

Likewise, investors too fall victim to recency bias by giving more importance to near term performance over long term performance. “In God we trust, all others must bring data” said W. Edwards Deming. Deming, a champion of using data and measurement, suggested that problems should be solved through robust data collection and analysis.

We analysed the performance of all equity mutual fund schemes for consecutive three year periods and ranked them. We then calculated the correlation between these ranks. Two specific results present important lessons for investors who tend to invest in the best performing fund. The best performing scheme of one three-year period in 2014-16 was ranked as low as 223rd after a period of three years. The negative and low correlation between the ranks for different three-year periods indicate that choosing the best performing scheme cannot guarantee superior long-term performance.

Like in cricket, recency bias in investing leads investors to extrapolate patterns and make projections based on near term performance. Funds that have delivered spectacular returns in the recent past appear unduly attractive. A better approach would be to first choose a fund house with a defined investment philosophy, stick to asset allocation and evaluate the long term track record.

The writer is head, Products, Motilal Oswal AMC