“Equity investing is about what could happen, not what has” – Michael Goldstein
We have highlighted on many occasions the three facets of investing that most impact performance: market participation, asset allocation, and cost. We can further segment costs into three areas:
- Direct costs of management fees and investment vehicle fees that we attempt to contain through the use of low cost ETF’s.
- The general and consistent underperformance of active stock selection techniques that we eliminate through the use of index-based investing.
- The last, and potentially most impactful, cost is making the wrong decisions at the wrong time to enter or exit the market.
We have all heard the phrase ‘buy low and sell high’. However, very few investors have been able to actually accomplish this feat. As the chart below shows, money flows into equity funds after a period of strong market returns and flows out after periods of poor performance. The old adage is flipped on its head and becomes ‘buy high and sell low’. That is clearly not the best method of protecting and increasing purchasing power.
One of our research providers published a recent research paper by Jason Hsu of UCLA that looks at this behavior in greater detail. Dr. Hsu and his co-authors analyzed a buy and hold strategy and compared it against actual investment results. What they show is that most investors make poor timing decisions by over-reacting to recent market movements. Surprisingly, the paper shows that most investors would achieve better investment results by flipping a coin rather than reacting as they do.
Source: “Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies.” Jason Hsu, UCLA
It is disturbing, yet understandable, that the action to change the course on an investment is wrong more often than not during times of stress. Investors would be better off just flipping a coin. Buying low and selling high is easy on a philosophical level, but human nature tends to prevent execution due to irrational behavior at times of duress. Unfortunately, this is not true of just individuals. Professional investment managers suffer the same consequences. We believe it comes down to the premise that when markets fall, we feel something needs to be done. Decisions need to be made and actions need to be taken.
In the professional investment world, we attribute this momentum style of investing to marketing. Those serving the financial industry need to convince people to buy their services (as do we). They need to differentiate themselves from the pack (as do we). They need to appear smart with a better method (as do we). Most do it through shuffling investments around on a monthly basis to show action (we do not). We don’t because empirical evidence shows that one risks taking action without the required level of confidence to justify said action, thereby, reacting to recent history and losing the wisdom created over time. The numbers above show it plain as day.
“Just because we can trade something doesn’t mean we should” – Rochester Cahan
Action for action’s sake is wrong. We see this in the complicated investment schemes presented to individuals and institutions by investment managers that attempt to outsmart the market over short time spans using stop loss strategies, sector rotation strategies, or options-based strategies. All these strategies appear wonderful on glossy paper as they display a high level of action taken by managers. However, few investors stop and ask if the action is justified by the level of confidence in the decision. Few investors should have the confidence in their decision making process when, at its core, it is a reactive strategy.
No action is not that same as inaction from our perspective. It takes as much effort to decide not to do something as it does to act. The intent, however, is to act in accordance with the fiduciary duty to build wealth for the client over time. The skill to investing is to ‘right-size’ the decision to match the level of confidence you have in the decision. That can only come through extensive analysis and a rigorous and disciplined investment process. It won’t, and hasn’t, come through following the short-term swings in the market. Knowing what indicators to follow and how to scale their importance so that emotion is removed from the equation is very important. That is where we focus our attention, efforts, and time.