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Recently, an investor told me that he is selling underperforming funds and buying those that have performed.

Perfectly rational thinking – Or is it?

Today we’re inundated with near-real-time information. Investors can track (and obsess over) daily NAVs, and financial channels and influencers amplify this multi-fold. This noise makes us forget that markets are cyclical, and different investment strategies have varying time horizons. We believe that hyper-transparency in NAV data is an advantage, and should guide our decision-making.

But what if it is a psychological trap, one that triggers a negative feedback loop that actually causes more underperformance?

Our brains are wired for escape from immediate threats, and not for long-term compounding. When we see declines in NAV, we view this emotionally – as a threat. When coupled with hyper-availability of information, the threat is amplified. So we panic and sell.

And typically, this is not an isolated decision. Our reactions mirror those of many other investors. If hundreds or thousands of investors sell at the same time, the fund manager has little choice but to sell some of their holdings. They have to redeem your money the same day.

So what happens?

They sell winners, which are usually more liquid and saleable. Or they sell stocks that have long-term potential but near-term negative news. Or they hold more cash, so they can pay out when needed. Or, they buy more index stocks – a phenomenon known as “closet indexing”.

All these actions might actually reduce returns. And they do.

But we are all caught up in the need for more information and transparency. And therefore stuck in the “recency” trap, where we extrapolate the last month or quarter.

In reality, the best returns on stocks are earned by having a long-term outlook. Some of the greatest investments might be in stocks that face near-term headwinds, but have superior long-term potential.

But our emotions and fixation on the rearview mirror (yesterday’s returns) often force fund managers into making the wrong decision.

It’s instructive to look at what one of the greatest investors of all time, Warren Buffett, did when he ran an investment partnership between 1956 and 1969. He operated with strict secrecy rules, not revealing specific stocks or investments to his clients. This was not due to arrogance, but a desire to keep his investors focused on long-term performance rather than short-term noise.

This allowed Buffett the freedom to execute his strategies without having to deal with his investors’ emotions and anxieties. The rest is history.

All this provides room for thought. Today’s active fund managers do not have the same freedom as Buffett did, as regulation and investor demands force them to operate in a fishbowl.

In the quest for more and more information and transparency, are we condemning our fund managers to mediocrity?

Would love to have your views. Please post in the comments section.