Are You Your Own Worst Enemy? Trying to Beat the Market vs. Letting It Work for You

One of the most common bits of counsel that we offer to clients who are investing for long-term growth is to avoid emotional reactions to market movements, either positive or negative. Of course, the negative volatility in response to the coronavirus outbreak and subsequent pandemic is very fresh in everyone’s mind right now; in March and early April, we saw markets plunge more than 30% from all-time highs. During those periods, it was very difficult to remain dispassionate about the markets, as investors watched the value of their portfolios shrink before their very eyes. The temptation to “sell everything before it’s too late” was strong, and many investors succumbed to it.

But it’s not just falling markets that can trigger investor behavior that runs counter to favorable long-term portfolio performance. In a rising market, when it seems that everyone is making more money than you are, it can be hard to resist the urge to jump on the bandwagon and even to “bet the farm,” straying outside sound asset allocation guidelines in order to obtain inflated returns.

Both of these classic investor responses to market movement are harmful to long-term portfolio growth, as multiple research studies attest. One reason is the cost of maintaining an active strategy that seeks to time the market, buying and selling at the “perfect” times to capture maximum return. In a September 2015 research article, “The Cost of a Perfect Market Timing Strategy,” Stanley W. Black and Samuel Wang of Dimensional Fund Advisors reported on a scenario in which an investor would use a combination of stocks and stock options to create an almost perfect correlation with perfect market timing. Sure enough, the strategy would have grown a $100 investment to almost $146,500 during the period October 1962–December 2014. But when the transaction costs are backed out, the investor would have been left with a mere $6,086—far less than the $18,273 yielded by the S&P 500 index during the same period.

Similarly, some investors believe that moving in and out of various sectors—from value stocks to growth stocks, for example, or from small company stocks to large company stocks—is the way to capture a premium over the broad market, as certain sectors will tend to respond differently during various parts of the market cycle. While it is true that diversifying across stock sectors is a valid strategy for minimizing volatility in a portfolio, the problem comes with trying to guess correctly which sector will be “hot” during any given period of time. As researcher Wei Dai demonstrates in a March 2016 article for Dimensional Fund Advisors, “Premium Timing with Valuation Ratios,” even very sophisticated mathematical models of the various stock sectors cannot predict, with better than random accuracy, which sector will outperform during any given period. In fact, the article indicates that out of the 680 different simulation models tested, no single timing method consistently outperformed a simple buy-and-hold strategy.

Additional research could be cited, but the point becomes clear: when investors attempt to time the market—especially by making buying or selling decisions based on an emotional reaction to market events—they end up hurting themselves the vast majority of the time. And we need look no farther than spring 2020 to see another reminder of this. Those who reacted to the sharp fall in stock prices in March and early April by selling stocks missed out on much of the sudden recovery that occurred late in April and in May. Though they may have gotten back in when prices rose enough to be reassuring, it will take them years to recover the gains they could have enjoyed, simply by staying put and riding out the volatility. In fact, some portfolios may never obtain those missed gains.

The financial markets can be a strange and intimidating place; no one questions that. But we are here to help take some of the mystery and anxiety out of investing for our clients. We help our clients structure a portfolio that reflects their unique goals and tolerance for risk. If you have questions or concerns or would like a Second Opinion on your portfolio, please feel free to contact us.

Buen Camino!