May 19, 2013

 

Every year the research firm Dalbar publishes a study that compares investor returns to stock market returns. Almost every year the study shows that investors do worse than the market. The reason seems pretty clear: poor timing.

The latest study looks at the 20-year period from 1992 to 2012:

• Average yearly stock market return = 8.21%
• Average yearly investor portfolio return = 4.25%

If you invested $10,000 in the stock market 20 years ago, and you didn’t touch it for the entire period, it would be worth $46,610 today. But if you tried to “time” the market by buying and selling during those 20 years, your $10,000 investment would only be worth $22,990. Poor timing is very costly.

Why is the average investor so bad at timing? And why do investors even try to time the market in the first place? Psychologists say it’s simply part of human nature. Despite knowing better, we give into the emotions of fear and hope. When the market is going down, we often give in to fear.

But we don’t sell at the beginning of a market decline, we sell when it’s closer to the end. We typically wait until the market has gone down so much that we can’t stand to take any more pain.

And then we compound the problem when the market recovers. We are often late in buying back in. The end result is a classic pattern of “selling low and buying high,” just the opposite of what we should be doing.

So what can you do to change this pattern of behavior?

Like any destructive behavior the first step to fixing it is to admit that there is a problem. Start by taking a full and honest look at your personal investing track record. Don’t rely on memory; look at your account statements.

• Did you sell some of your stock holdings during the market meltdown of 2008-2009?
• Did you get back into the market in 2009?
• Did you sell in 2000-2002? When did you get back in?

Here are some other suggestions.

Have a written plan. Bear markets will always be with us, but when you have a plan you will be prepared when they arrive. If you want to avoid big market declines, start by defining exactly what you mean by “big.” Declines of 10% in the market are common, and it’s nearly impossible to avoid them. But you could create a rule that says “if the market declines by more than 10%, I will sell half of my stock holdings.” This will give structure and discipline to your sell decisions, and it will help take emotions out of the process.

Make a checklist for selling decisions. This list could include things like your 10% rule, your reasons for wanting to sell, and your criteria for getting back in when the coast is clear. It can also include a requirement that you discuss your intention to sell with a trusted friend or adviser before you pull the trigger. The checklist helps to reduce emotion and increase rationality.

Don’t participate in market timing at all. For some investors, the pain of “riding out” a big drop in the market is too much to bear. But for many, especially those who have 10 or more years until they need the money, doing nothing is the best solution to poor timing. Would you rather earn 8% per year, or 4%? If you have the emotional strength to ride out the storms, it could be as simple as that.

About the author 

Erik Conley

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

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