Investing isn’t rocket science, but that doesn’t mean it’s easy. One of the most difficult parts of investing is knowing what to pay attention to, because without the right knowledge and perspective it’s easy to be your own worst enemy.
While many investors fixate on headline risks popularized by the media (e.g. weak economic data, international turmoil, etc.), the reality is that investors have very little control over these matters.
Among the investing public, however, there’s a widespread misconception that investors can control headline risk by timing the stock market. Attempting to time the stock market takes many different forms and includes changing a portfolio’s overall stock/bond/cash allocation based on:
- Current events or news
- Broad economic data
- Charts that attempt to predict the future based on the past
- Data that does not fundamentally affect the intrinsic value of portfolio holdings
The Human Psyche and the Pain of Loss
Most attempts at market timing are driven by fear of loss, a phenomenon known as loss aversion bias. Academics have documented that the pain of a given loss is felt twice as acutely as the joy associated with a gain of the same magnitude.
Unfortunately it’s this bias that leads many investors to move money out of stocks at inopportune times, usually after the market has already fallen to low levels. Markets typically bounce back much more quickly than people expect, and the vast majority of attempts at market timing end up hurting returns.
The Performance Gap
Few studies illustrate the counterproductive nature of market timing better than DALBAR’s Quantitative Analysis of Investor Behavior (QAIB). This study examines the effects of investment decisions made by mutual fund investors over short and long periods of time.
The magnitude by which the average investor’s performance lags behind the broad market is astounding – over the past 20 years through 2015 the S&P 500 generated an average annualized return of 8.19 percent while the average mutual fund investor’s return was a mere 4.67 percent.
Perhaps even more telling is that the DALBAR gap in annual performance nearly doubles when the time period is extended to 30 years to cover three chaotic market corrections – the crash of 1987, the bursting of the technology bubble in the early 2000s, and the financial crisis of 2008-09.
The DALBAR study found that this performance gap is primarily attributable to poor investment decisions, although it’s worth noting that sequences of returns can also play a big role in studies of this type.
The Odds of a Stock Market Crash: Availability Bias
If market timing leads to such poor results, why is it attempted so often by so many? A recent study led by Robert Shiller, the Nobel prize-winning economist at Yale University, indicates that chaotic market declines may have a psychological effect on some investors that can lead to bad decisions.
Shiller’s study surveyed investors from 1989-2015 and asked participants to assign a probability to the likelihood of a one day stock market crash of 12 percent or greater occurring in the next 6 months. On average, the participants estimated the probability of a one day crash to be 19 percent. The actual probability of such an event taking place in a six month period is about 1 percent.
Even more significant than this gross miscalculation is the impact that recent market performance has on participants’ estimation of the odds. Shiller’s study indicates that investors place higher odds on a crash after a recent drop in prices, and lower odds on a crash after recent gains.
Lower Prices Mean Less Risk, Not More
The root of the problem lies in investors’ perception that the stock market is riskier after a correction, when the reality is that the market is cheaper, and therefore, less risky.
Investing isn’t easy, but it’s easier to prevent fear and greed from turning you into your own worst enemy with the understanding that the human psyche is often geared to compel counterproductive action. Talk to a CFP® professional to gain greater perspective on smart investing.