Recency bias — why chasing past returns destroys wealth

The instinct to invest in what just did well — whether sectors, fund categories, or specific funds — is among the most consistent destroyers of investor returns. The leaderboard of "best 1-year returns" attracts inflows just as the underlying conditions that produced those returns are unwinding. Funds chasing investors regularly catch the reversal rather than the rally.

The persistence question

Does past performance predict future performance? Decades of mutual fund research suggest: only weakly, and only over very specific frames. For Indian equity funds:

• Over 1-year windows: top-quartile performers in year N have a roughly 30-40% chance of being top-quartile in year N+1. (Pure chance would predict 25%.)
• Over 3-year windows: persistence drops further; only 25-35% of top-quartile 3Y performers remain top-quartile in the next 3Y.
• Beyond 5 years: persistence is near random.

The takeaway: past performance is a noisy signal. It's not random — there is some genuine manager skill — but it's not strong enough to support the chase strategy.

Why chasing produces underperformance

Even with the modest persistence signal, the act of chasing produces sub-par outcomes for behavioural reasons:

You buy after the run-up

You notice a fund only after it's already produced a 50% year. The valuation that drove last year's gains may have already peaked. Your entry price is high; future returns are likely to mean-revert.

You sell after a drawdown

The fund you abandoned to chase the winner had a bad year. You sell at the low. The fund you abandoned often goes on to recover; you missed the recovery.

Tax cost of switching

Each switch is a taxable event. Equity LTCG at 12.5%, stamp duty 0.005%, STT 0.001%. Over a multi-decade career of switching, the tax drag compounds significantly.

Increased transaction costs

If you're switching funds within 12 months of purchase, exit load applies (typically 1%). Combined with tax, the switch needs the new fund to outperform by 2-3% just to break even.

The sector-rotation chase

One especially destructive variant: chasing sector or thematic performance. PSU funds returned 70%+ in 2023; they attracted heavy inflows in early 2024. The 2024 return was 5-15%. International funds gained heavily in 2020-2021; flows in 2022 caught the drawdown.

Sector winners alternate by year almost randomly. Last year's hot sector is usually next year's cold sector.

What persistent funds look like

The funds that show longer-run persistence usually have:

• Stable fund management — same manager for 5+ years.
• Coherent investment philosophy, articulated and consistent over time.
• Reasonable expense ratios (top-quartile peers tend to have lower TER).
• Sticky investor base — low redemption rates during drawdowns.

These features take time to assess. The shortcut of "top 1-year return" misses them entirely.

The counter-strategy: avoid the chase

The most successful long-term investor pattern is the opposite of chasing:

1. Pick 3-5 diversified equity funds at the start. Mix categories (Large Cap + Flexi Cap + Mid Cap, maybe + Small Cap if your tolerance permits).
2. Set up SIPs.
3. Do not switch based on year-on-year performance unless the underperformance is structural (manager change, mandate drift, persistent 3+ year category underperformance).
4. Use the annual review to verify the funds are still doing what they were chosen to do — not to chase what's currently winning.

When to actually switch a fund

Real reasons to switch (not "did badly recently"):

• Manager left and the replacement has weak track record or unclear approach.
• Fund mandate shifted (e.g. a Flexi Cap became effectively a Large Cap).
• AMC has had multiple regulatory issues or compliance problems.
• Persistent underperformance vs category for 3+ years with no obvious explanation.
• Your goals or risk profile changed; the fund no longer matches.

The hot-fund recovery story

The classic chase trap: a fund had two great years; you bought it; it had a bad year; you switched out. The next year, your old fund had the strongest recovery in its category. The new fund you bought had a flat year. You lost on the round trip.

This story repeats so frequently that some researchers call it the "investor return gap" — the systematic shortfall of investor outcomes vs fund returns.

Practical defences

• Don't subscribe to "top 5 funds for [year]" emails.
• Don't change funds based on Morningstar / Value Research one-year rankings.
• Use a 5-year evaluation window minimum.
• Compare funds against their category benchmark and category average, not against an unrelated top performer.
• If you're tempted to switch, write down why before acting; come back after a week.

The case for some diversification across categories

If you genuinely don't know which category will lead over the next 10 years, diversification across categories is the rational hedge. Holding a Large Cap + Flexi Cap + Mid Cap + Small Cap basket means whatever category leads next year, you participate without needing to predict.

The cost of diversification: you'll always have one or two underperforming funds in the basket. That's expected and fine. The aggregate outperforms chasing.