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We’ve all been tempted. Whether there’s a hot new sector that seems to be on fire, or a classic U.S. company that seems poised for a new burst of life, or, worse, a pundit who keeps warning us not to get caught flat-footed.
It’s human nature to be attracted to the next shiny new thing. My 2-year old son was perfectly happy playing with his trusty push truck, for instance, until he got a shiny red Matchbox car for his birthday and abandoned the – still very serviceable – truck.
It’s also human nature to try to catch winners on the way up and want to abandon the underperformers. But that doesn’t mean it’s always a good idea.
While the market as a whole has done quite well over the last 20 years – the S&P 500 has returned approximately 9.9%, and a diversified portfolio of 60% stocks and 40% bonds would have returned 8.7% [1]– the same can’t be said for the average investor.
During the 10 year period from 2003- 2013, the average investor’s portfolio only returned 2.6% annually, [2] barely a quarter of what the S&P returned, and not much higher than the rate of inflation.
What’s the reason for this underperformance?
By trying to beat the market by chasing performance, by trying to time markets, and by overpaying in fees, investors hurt their returns significantly.
Chasing Returns
When a particular investment is performing well, investors often get excited and invest more, causing the price to continue to climb. As it does, more investors are attracted to its returns – even as the stock becomes more expensive – causing the price to rise even more.
Eventually however the investment will return to its intrinsic value, and fluctuate slightly around that number.
When that happens, the investors who tried to chase performance and bought on the more expensive upswing, will lose money or underperform the market.
Timing the Market
It is not surprising that investors try to time the market. If we were able to predict when markets would top and when they would bottom, we’d all be enjoying extraordinary returns. In reality, however, very few people who try to time the markets actually succeed.
According to Morningstar, market timing costs the average investor 1.5% annually. For a hypothetical portfolio that returned 8.7% annually, a 1.5% additional ‘expense’ ends up eating up over 17% of the investor’s returns.
Warren Buffet once said, “the only value of stock forecasters is to make fortune tellers look good.” Famed investor Peter Lynch said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves”. [3]
If Warren Buffet and Peter Lynch don’t believe in trying to time the market, and studies have shown that strategies that try to time the market have very low success rates, it’s a good sign that you’re probably better off not trying too.
Overpaying Fees
If you are chasing returns, and trying to time the market, chances are you are making more trades than you would with a buy-and-hold strategy. That means you are paying more fees, which also affects your overall rate of return negatively.
A Potential Solution
The smarter approach may be to do less . Investors have historically hurt their returns by over-trading. Looking at your portfolio too often or constantly checking up on how the markets are doing can be detrimental to your finances if you are prone to reacting too impulsively. Rather than trying to time the market, or always buying the next hot stock or asset class, investors tend to have more success by taking a hands off approach.
Yes, his red Matchbox car is shiny and bright. But, as my son grows up, I hope he’ll learn to value the tried and true as well. And smart investors do the same, thinking carefully before they leap into the next big thing, or try to catch the current wave and ride it to the top.
Sometimes doing less is doing more.