So far this year, the investment markets have been like a roller coaster — falling precipitously one day only to rise the next day and then perhaps fall again the day after that.
When markets experience this kind of volatility, it can be tempting to try to increase returns by timing the markets — or in other words, buying on the dips and then selling when prices have gone back up again. If only it were this easy.
A Fool’s Game
Both research and real-world experience have demonstrated that chasing investment performance by trying to time the market is a fool’s game. History has shown that it is nearly impossible to predict with any degree of consistency what the next hot asset class is going to be — much less the next hot stock. This is true not only for average investors, but also for investing pros.
The Dalbar Quantitative Analysis of Investor Behavior is an annual study that measures the effects of investors’ decisions to buy, sell and switch into and out of mutual funds — or in other words, to try to time the markets. The 2015 study determined that when investors try to increase their portfolio returns by timing the markets, they often become their own worst enemies.
According to this study, there is a wide performance gap between what investors could earn by not trying to time the markets and what the average investor actually earns. In 2014, this gap was a whopping 8.19% for the average equity mutual fund investor, who earned just 5.50% in 2014, compared to the broader market return of 13.69% as measured by the S&P 500.
Longer term, the annualized 20-year return for the average equity mutual fund investor at the end of 2014 was just 5.19%. This was 4.66 percentage points lower than the S&P 500’s 20-year annualized return of 9.85% over the same period.
Dalbar blames the performance gap on what it calls bad investor behavior — primarily, selling securities in a panic when markets fall and then buying them back again when markets rise. While this might be an understandable emotional response to market volatility, it’s a sure formula for investment losses. In essence, it practically guarantees “buying high and selling low” — the exact opposite of a successful investing strategy.
The Role of Investor Psychology
Investor psychology plays a big role in the general failure of market timing as a strategy for successful investing. There’s certainly no shortage of available investment information today — the Internet and cable TV networks like CNBC offer 24/7 advice on market moves that will supposedly make you rich. In fact, you could say that there’s way too much investment information out there for the average investor to try to digest.
As a result, many do-it-yourself investors just end up listening to whichever media voice is yelling the loudest. However, this voice doesn’t know anything about any particular investor’s goals, risk tolerance, timeline or anything else that’s unique to his or her situation.
Another thing to remember about market timing is the fact that the stock market is very inefficient over the short term. As we’ve seen lately, stock market indices like the Dow Jones Industrial Average and the S&P 500 can swing wildly from day to day and week to week. This is due mainly to changes in investors’ perceptions about the performance and outlook for stocks and the economy — or in other words, on emotions. Over the long term, however, the stock market performs very efficiently.
That’s why creating a balanced portfolio with the proper asset allocation is a better way for most investors to achieve long-term returns than trying to time short-term market moves. A well-constructed portfolio will spread your assets out among the three primary classes of stocks, bonds and cash equivalents based on your goals, time horizon and risk tolerance. This will help reduce portfolio risk and volatility by not putting all of your assets into a single type of asset class.
If you feel tempted to try to time the markets in the midst of this current bout of volatility, please give us a call before making any moves. Together we will discuss the best strategies for your particular situation.