The Trouble with Market Timing

Human brains cope badly with failure – we take mistakes personally and hate facing up to them. The result is that we often do tremendous harm to our investment returns

Every once in a while most of us get a strong feeling that markets are going to fall. When that happens we are tempted to take risk off the table by selling all, or part, of our portfolios. This often results missing out on an upswing because we are reluctant to accept we were wrong. In order to benefit from this strategy you have to be prepared to buy back in to the market when the news and outlook are even worse than when you sold!

Each year the Dalbar Quantitative Analysis of Investor Behaviour (“QAIB”) measures the returns actually made by US investors in mutual funds, taking account of their decisions over when to buy and sell, as well as the underlying performance of the funds. Since most funds fail to beat the index after charges we would expect to see a modest degree of underperformance.

What the survey actually shows is a massive and consistent trend of poor decisions. In 2014 alone, whilst the S&P 500 delivered 13.7%, equity mutual fund investors only made 5.5% – an undershoot of more than 8%. Over longer periods of time the same trend is clearly apparent. The conclusion seems unambiguous – attempts by investors to time market movements result in considerable damage to returns. Interestingly, a more detailed part of the survey suggests that US investors get timing decisions right more than half of the time; the trouble is that the losses from the bad decisions greatly outweigh the pluses.

The successful trading bets encourage confidence that we know what we are doing but when it goes wrong we are late to face up to a bad call. By the time we do, markets have risen sharply and the lost returns can be huge.

One of the most critical parts of the EQ advisory process is to assess clients’ attitude to risk and make sure that you are comfortable with the characteristics of your portfolio. No-one can predict accurately when markets will enter a period of turbulence. Our aim is to make sure you do not panic when that happens, because the evidence suggests that can cause huge damage to returns.

1. Returns are for the period ending 31 December 2014. Average equity investor and average bond investor performance results are calculated using data supplied by the Investment Company Institute. Investor returns are represented by the change in total mutual fund assets after excluding sales, redemptions and exchanges. This method of calculation captures realised capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: total investor return rate and annualised investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions and exchanges for each period.