Recently, I was at a conference where a 30-year veteran of the investment business was talking about the need to be flexible. No investment strategy works all the time, he said. Value investing (buying companies that look cheap on metrics such as price/book and dividend yield) has beaten growth investing (buying firms that are forecast to have higher earnings growth) over the long term, but has had periods of underperformance.
The last few years have been notably tough on it, as were the late 1990s. So people need to adapt to market conditions rather than stick to the same approach.
For investment managers, that might be sound career advice. Underperform your peers for too long and your job will come under threat. It’s safer to deliver a mediocre performance in line with everybody else than to risk standing out as you wait for your strategy to come good (hence the problem of closet indexing – funds that claim to be actively managed but consistently stick close to their benchmark – that blights the industry). But for private investors, it’s bad advice.
Why is that? Trying to switch between different investment styles according to which you think is likely to do best over the short term is a form of market timing. And there’s abundant evidence to shows that most people are not very good at doing this.
While there may be a small number of traders who can time market moves profitably, and through skill rather than luck, most can’t. Indeed, investors’ attempts to move their money between different funds to capture what’s hot provides a striking example of this.
Market timing is a costly folly
Every year Russel Kinnel of Morningstar publishes a review called “Mind the Gap” that uses US mutual fund flows to compare the average return earned by funds to the money-weighted returns earned by investors in those funds.
If investors were good at timing the market, you’d expect to see a positive gap between money-weighted returns and average returns (because investors would be putting more money into the types of funds that subsequently did well). But the reality is just the opposite.
Over the ten years to 2014, the average return on all funds has been 5.75% per year. But the money-weighted return has been 5.21% – a gap of -0.54%, causing by investors’ poor timing decisions. The size of the gap moves around from year to year: the latest numbers were far better than the -2.49% over the ten years to 2013, as the impact of the early 2000s bear market dropped out (investors make especially poor decisions at market bottoms). But the gap is consistently negative.
What’s especially unfortunate about this is that investors manage to erode any gains from following sensible strategies. Over time, value investing works: the average value fund earned a return of 9.36% per year between 1991 and 2013, according to Research Affiliates.
But the money-weighted returns on value funds over the same period were just 8.05%, a gap of -1.31%. What’s worse, the gap between that and the return on the S&P 500 was -0.92% – meaning that poor timing decisions more than wiped out the entire excess return earned by value strategies. The lesson is evident.
Investors should choose one or more strategies that appear to work over the long term (whether that be value investing, low-cost diversified asset allocation, or whatever you favour) and stick to the plan. Chopping and changing will only leave you worse off.
You really can’t buck the market
It’s relatively easy to study the impact of investors’ timing decisions on their returns from funds, because information on money flowing into and out of funds is readily available from databases such as Morningstar.
Researching whether people who own individual stocks do any better is more difficult, because data on their buying and selling decisions isn’t readily available. However, there is a handful of studies that have drawn on data from discount brokers around the world.
Probably the best known of these studies is Trading is Hazardous to Your Wealth by Brad Barber and Terrance Odean, which used data from 78,000 accounts at a large US discount broker. This found that the average client underperformed the market by 1.5% per year after costs.
The data are now old (the study was published in 2000 and based on trades from 1991-1996), so it’s likely that the impact of costs may have shrunk a bit due to the arrival of online trading. But it seems unlikely that human nature has changed much, and more recent studies in other countries tell a similar story.
These suggest investors consistently make poor decisions, tending to sell their winners early and holding losers in the hope that they will turn around. The obvious conclusion is that investors should give up on trying to beat the market and settle for holding a diversified portfolio of low-cost index funds. But for those of us who enjoy managing our own money, these studies hint at a few ways in which we can improve our chances.
The first is to hold down costs: several studies imply the average investor may beat the market before costs. The second is not to trade too often: Barber and Odean found that the 20% of accounts with the lowest turnover was the only group to beat the market after costs. The outperformance was small and not statistically significant, and this group was still guilty of selling winners too early – but it was the only one that came close.