Investors who attempt to time the stock market run the risk of missing periods of exceptional returns. This practice may have a negative effect on a sound long-term investment strategy.
As shown below, we can see the returns for a hypothetical $1 investment in stocks, stocks minus the best 13 months (5% of the total time period), and Treasury bills. An unsuccessful market timer, missing the best 13 months of stock returns, would have earned a return similar to that of Treasury bills. How would an investor know, in advance, when one of the 13 months is about to happen? According to Warren Buffett, “The stock market is a device to transfer money from the impatient to the patient.”
There are more important aspects of investing that will determine your long-term success such as; Understanding the purpose or potential use for the funds, your investment time horizon and risk tolerance, the allocations to stocks, bonds and cash, the specific asset classes chosen and, finally, the particular investments that are selected. Although successful market timing may improve portfolio performance, it is very difficult to time the market consistently. You have to be right twice each time-when to sell and when to buy again. The only way to guarantee that you capture 100% of the return of the stock market is to be invested 100% of the time.
When it comes to measuring investment returns there is more than one method. The most common is nominal return which includes inflation. The other measure of return is called real return. Real return is measured by taking the nominal return less the inflation rate. Real return is vital because it measures the increase in purchasing power that your investments generate.
If Investor A achieves a 10% return and Investor B achieves a 1% return, most people would say that Investor A did much better than Investor B. Let’s now say that Investor A had to deal with an inflation rate of 10% and Investor B was in a 0% inflation environment. After inflation Investor A actually did not increase their purchasing power while Investor B added 1% to their purchasing power. This is important because even though Investor A had a nominal return that was 10x that of Investor B they can’t buy more than before. On the other hand, Investor B would have added 1% to their purchasing power. Meaning the 1% nominal return is actually better than the 10% return when adjusted for inflation.
Let’s take a look at how the three primary asset classes have performed before and after inflation. As you can see, stocks have easily produced a positive real rate of return with bonds offering a real return equal to roughly one-third that of stocks and cash-type investments producing a fractional real return.
After inflation, taxes and a recommended maximum 4% annual withdrawal rate for retired clients the only asset class that will protect their purchasing power is stocks. That is why stocks have to play an important role in a retirees investment portfolio. While bonds do not offer the same long-term growth potential they need to be included in a balanced portfolio. They are a more dependable source of income and will serve as a ballast when stocks experience periodic setbacks. And while cash-type investments are safe in the short-term they expose an investor to the risk that their purchasing power will decline due to inflation.
Morningstar has spent years studying the returns investors actually earn versus the returns the funds earned. Through this study, Morningstar has found that the behavior of an investor whether by attempting to time the market, selling during a downturn or buying after a rally has resulted in the same outcome - the average investor earning a lower rate of return.
Here’s an example - Imagine that a fund with $10 million in assets earns a 100% return from Jan. 1st to Dec. 31st. Assuming no one added or took money out of the fund it would start the next year with $20 million in assets. In the new year investors flocked to this fund adding $100 million on January 1st because of its previous years performance bringing its assets to $120 million. In year two, however, the fund loses 50% of its value. An investor who invested at the beginning of year one has broken even over the full two years while those who entered into the fund in year two have lost 50% of their investment. As a group they gained $10 million in year 1, but lost $60 million in year two. Adjusted for the timing and amount of inflows, the average investor lost about 42% annually in a fund that officially reported a 0% return over the two year period. Simply put, it is unwise to chase performance.
The average investor has underperformed the fund investments they own by an average of 1.6% per year over the long run. Over a 10 year period an investor that underperformed by 1.6% per year would have earned about $300,000 less than the fund itself (assuming a $1,000,000 portfolio, an 8% rate of return by the fund, a 6.4% return for the average investor, and no withdrawals). The gap between the returns tend to be greater for funds that are riskier (equity funds) since they invoke more of an emotional response by investors due to their higher volatility. As financial advisors part of our job is to eliminate that gap for our clients by removing the behavioral mistakes resulting from swings in the market.
On average, trying to do better makes an investor do worse. It feels great to buy more when an investment had been going up, and it hurts to buy more when an asset has gone down. An investor that tends to raise their exposure to assets that have gotten more expensive (with lower future returns) and to reduce it when they are cheaper (with higher future returns) guarantees they will underperform. Why is it that people want to buy everything else on sale except their investments?
In the end, emotional responses to market events significantly hurt the average investors performance.
There are many different investment approaches. One that has proven to be successful over the long- term is the contrarian approach. A contrarian approach means that an investor rejects or opposes popular opinion and invests in assets that are not as highly valued in the current day with the expectation that they will enhance returns over the long run. This does not mean that an investor buys assets that have decreased the most, but rather assets that have strong fundamentals and are out of favor in the current market. The key is focusing on fundamentals, not feelings. Over the long run, an investor will have a much higher rate of success with buying near the lows and selling near the highs. This approach forces an investor to have a long-term view and position their portfolio for the next five to 10 years rather than for the next quarter or year. As the great investor Warren Buffet has said, “Be greedy when others are fearful and be fearful when others are greedy”.
We continue to hold an overweighting in both emerging markets and international equities because their valuations are cheaper relative to US markets. Current value measures tell us that these equities have the most room to grow over the next five to 10 years as their valuations revert to historical levels. The graph below shows the expected returns over the next 10 years from Morningstar. This graph reflects similar analysis from other resources we trust.
We believe that by following a contrarian approach over the next 10 years in which we take profits (sell near the high) and rebalance into underperforming assets (buy near the low) the returns that are earned can be improved. At the same time, we want to be clear that the current high-valuations for US equities and low starting yields for bonds will make for a challenging environment.
As we experience a rough October for global stock markets, we think that it is a good time to discuss equity returns and the benefit of having a long-term view. Over the course of the last 91 years, equities have returned about 10% annually. The 10% average gain comes with short-term volatility however. The chart below illustrates that the longer your holding period or investment horizon the more likely you are to experience gains. At Von Holt Financial Advisors, we preach a 5 year or greater investment horizon. As the chart below shows, having a 5-year horizon rather than a 1-year horizon reduces the chance of experiencing a decline from 26% to just 14% of the time. Stretching the time horizon to 15 years results in not a single period in which a loss occurred.