The folly of panic selling and market timing
A recent DALBAR study found that over a 30-year period, the average self-directed equity mutual fund investor earned only 3.7 percent, compared with 10.3 percent that could be obtained by simply investing in a S&P500 index fund. Much of this huge shortfall is due to panic selling during market downturns, or attempts to time the market.
A typical scenario is that in the midst of a market downturn, investors panic and sell out, with the intent of waiting for the market to “bottom out” before reinvesting. Some investors believe that they can actually earn a tidy profit in the process. Sadly, the all-too-frequent experience is that the sell orders come near the market bottom, and by the time investors reinvest, the market has rallied significantly, leaving the investors with a permanent haircut on their investment portfolio compared to a simple buy-and-hold approach (not to mention the fees paid in the process).
In general, individual investors’ attempts at market timing are not only futile, they are measurably counterproductive. According to a Morningstar analysis, as recently summarized by Marketwatch, individual U.S. equity mutual fund investors earn 0.79% less annual return than their underlying funds. Individual U.S. fixed income fund investors earn 0.73% less. This may not sound like much, but over a 40-year investment horizon a 0.79% annual reduction from an 8% average annual return balloons to a 26% permanent portfolio loss.
As Morningstar notes, almost all of this reduction is due to amateurish attempts at market timing. If even professional market analysts and highly sophisticated computer programs struggle with market timing, what realistic chance is there that an individual investor, armed only with charts and graphs, can do better?
Active traders do significantly more poorly than those who trade infrequently or not at all (although it may be hard to convince such persons that their efforts are detrimental). According to a study by Brad Barber and Terrance Odeon of U.C. Berkeley, the most active U.S. equity traders achieved only about 62% of the return of those who trade infrequently. If we again assume an average 8% annual return for buy-and-hold investors and a 4.9% return for active traders, over a 40-year time horizon the buy-and-hold portfolio would be 3.2 times larger! As Barber and Odeon conclude, “trading is hazardous to your wealth.”
Gender and marital status
In a separate study, Barber and Odeon found that men trade 45 percent more than women, and that this trading reduced their overall rate of return by 14.2%, as opposed to “only” a 9.1% reduction for women. Again, over a 40-year time horizon, these losses are 35% of portfolio value for men and 24% for women. If we compare the average amount of “churning” (portfolio turnover), the figures are 77% for men and 53% for women.
These losses are even more pronounced for singles — the average annual portfolio churn for single men was 90%, compared with 50% for single women.
Why is there such a difference between the sexes? As Barber and Odeon observe,
Psychological research has established that men are more prone to overconfidence than women, particularly so in male-dominated realms such as finance. … Models of investor overconfidence predict that, since men are more overconfident than women, men will trade more and perform worse than women. Our empirical tests provide strong support for the behavioral finance model.
The two studies mentioned above by Barber and Odeon are now 17 and 19 years old. But from anecdotal exchanges with people in the industry, the situation is little changed — men are more likely to trade frequently, more likely to be overconfident in their investing, and more likely to achieve subpar rates of return.
Public policy implications
The phenomenon of excessive trading (and corresponding drops in performance) is exacerbated with the ease of online trading. In an earlier era, if one wanted to sell (or buy) some shares, one would need to call one’s broker, discuss the trade, and then wait for the broker to have the trade executed. Even though that was not a desirable situation, and fees were much higher, it did require time for more careful reflection and one-on-one discussion with the broker.
But now it is all too easy to trade. Major brokerages are currently engaged in a price war. For as little as USD$4.95 one can buy or sell a large block of stocks, bonds or exchange-traded fund shares. For certain exchange-traded funds operated by the brokerages, there is no fee at all (except for a small exchange fee).
Indeed, the rise of exchange-traded funds, which can be bought and sold anytime during the trading day, has prompted calls of concern that they are merely facilitating unwise investor behavior. Vanguard founder Jack Bogle, for instance, recently called (paywall) for politicians to re-examine ETFs. He noted that the returns achieved by Vanguard investors in their large mutual funds exceeds that achieved by investors in the equivalent Vanguard ETFs by 1.6%, almost certainly due to attempts by investors to time the market.
Still others wonder if the whole U.S. retirement system needs to be rethought, given its increasing reliance on user-directed 401Ks. Paul Merriman, citing a DALBAR report, assessed the situation in these terms:
The numbers change from year to year, but every DALBAR report comes to the same conclusion: Investors’ emotion-based trading is counterproductive… [Despite] enormous efforts by thousands of industry experts to educate millions of investors, imprudent action continues to be widespread. … The belief that investors will make prudent decisions after education and disclosure has been totally discredited.”
In the meantime, all individual investors can do is to keep focused on consistent long-term investment, preferably in very-low-fee index funds or the like, not attempting to time or second-guess the market. And given the results mentioned above for gender and marital status, maybe we all should try harder to maintain effective communication with our spouse or significant other, in order to avoid hasty and unwise investment decisions.