Many investors try to use market timing to increase their returns or to protect themselves against losses. It is understandable that they want to be invested as fully as possible when markets are rising and be on the sidelines when stocks are falling. But that is easier said than done. Market timing improves returns only if one buys more cheaply what one has in the past sold. Success requires an accurate prediction that the market will fall and two correct decisions: when to sell and when to buy. In retrospect it is always easy to see what one should have done, but do investors succeed prospectively? Broadly based studies as well as more than thirty years of personal experience show that very few do so.
It is easiest to see how investors typically behave in the following chart of in- and outflows into our Classic Global Equity Fund.
Investors bought a great deal of fund units in 2000 and 2001. The increase in the fund’s net asset value (NAV) convinced them that our investment process and value investing work. But when the NAV sank in 2002, few took advantage of the opportunity to buy or stock up at lower prices. On the contrary, there were more sellers. One has to assume that many of them were realizing losses. Unfortunately, very few people truly live the value principles that an equity investor owns not pieces of paper but fractional stakes in businesses. Normally the economic value of a company varies little, certainly much less than its shares. One should therefore buy when prices are low and companies are being traded below their economic value on the stock market.
From the fourth quarter of 2004 to the fourth quarter of 2007 the fund did not accept any new money because it threatened to become too big to be able to invest successfully in small companies. In 2008 investors started to get out of the fund as it dropped – the first of them at good prices. Unfortunately, the selling continued for the next five years. Only very few people used the low prices to get back in, maybe because they had lost their trust, maybe because they had become wary of equity investments in general after the second crash in ten years.
The investors behavior in the Classic Global Equity Fund could be observed in large-scale studies as well. Possibly the best one on the subject comes from the American research firm Dalbar, which was founded in 1976. Every year since 1994 it has been publishing a report entitled „Quantitative Analysis of Investor Behavior“, which measures the monthly inflows and outflows in all American mutual funds to calculate how well the investors have fared with these transactions in comparison to a simple buy and hold strategy (the relevant benchmark index). The researchers thus measured whether investors as a group succeed at market timing. This would be the case if American funds experienced bigger inflows before the markets rose and smaller ones before a correction. If the opposite were true, investors would have done worse than the benchmark. Dalbar used the S&P 500 Index as the benchmark for equities and the Barclays Aggregate Bond Index for bonds. The results are very clear (see the Appendix for bonds):
Passive investors, who held the market through an index fund, specifically on the S&P 500, would have done better than active investors who bought and sold, for example by 7.4%-points annually over the last thirty years. The market timer’s annual return of 3.7% reached only a third of the passive strategy’s. That difference was less pronounced over the last 20 and 10 years, but climbed again for shorter periods, that is, the most recent past. None of these comparisons take transaction costs into account. These, naturally, are lower with a passive buy and hold strategy than with one of active trading.
Taking the subscriptions and redemptions shown in the graph above, we performed an analysis using the method from the Dalbar study for our Classic Global Equity Fund. The results are pretty much the same.
If an investor had bought units of the Classic Global Equity Fund at its launch on December 16, 1997 and held them from then on, then his return of 11.7% per annum would have been more then double the 5.5% which the average investor in the fund actually earned as measured be the capital committed by all investors over time. (For those interested in the mechanics of this calculation: the 5.5% are the internal rate of return on all the inflows, outflows and the value of the fund end of 2013.) The big problem is not the purchases after the NAV has already gone up, it is the redemptions that are not followed by purchases at lower levels. The youngest Dalbar-Study complains: “TKTK – Bitte Original”.
Already Benjamin Graham, the father of modern financial analysis and the author of the bestseller, “The Intelligent Investor,” noticed this phenomenon many years ago and came to the conclusion that the biggest danger for the investor is himself.
There is much evidence that we humans, who are very emotional creatures, find it hard to take cold-blooded advantage of market swings. Greed and fear, the herd mentality and other powerful psychological dynamics, which have served us very well during the course of our evolution, turn against us when we invest – as I have already described in this blog on 10.12.2103 in the article “Cognitive biases and managing one’s career: why value investing works”. Most of us are probably best off not even trying our hand at market timing. Instead, we ought to pursue a buy and hold strategy, in particular as most of us have an investment horizon spanning decades and thus more than enough time to sit out periods of poor returns. If one buys and holds a fund that invests in the value style, which should allow an annual excess return of 1-2%-points, then this strategy is particularly advantageous in comparison to market timing.
Next month’s blog entry will take up the question of why it is very hard for even an extremely rational investor, a Mr. Spock of the financial markets, so to speak, to earn an excess return with market timing.
Dalbar observes the same pro-cyclical behavior among fixed income investors as among equity investors. It seems deeply anchored within us.
The above post was originally published on the blog of Braun, von Wyss & Müller.