Here's why market timing can be one of the most serious mistakes investors can make….
2022 has generally been a bearer of bad news for most Australian investors. With high inflation and interest rate hikes contributing to financial market volatility, we are seeing a lot more red in our brokerage accounts than we have in quite a while. To add to the list of worries, the fixed income component many rely on for portfolio stability seems to have temporarily come ‘unfixed’, with loses mounting in both bond and equity holdings.
But amid the short-term pessimistic outlook, here’s the silver lining that most people ignore. And it is that despite the recent bumps and blips in the financial market, the Australian share market has delivered an average rate of return of about 10% over long periods of time, making it one of the greatest wealth creation machines of all time. And when paired with the miracle of compounding returns, it truly is the secret to getting rich slowly. But here’s the catch - that 10% return only measures what buy and hold investors would have earned by putting money in at the start of the period and keeping it fully invested through good times and bad.
In trying market environments like these, our instinct for self-preservation comes to the fore, and it is tempting to seek shelter from the storm by turning to cash with some or all of your nest egg. But Vanguard looked at the consequences of doing that and unfortunately, it paints a grim picture.
The majority of us that try to time the equity markets get it wrong. Our emotions cloud our judgment and as it turns out, there is usually a cost for heeding our gut and result in negative outcomes for long-term returns.
Vanguard analysis of Australian investor behaviour between 2004 and 2013 – before and after the height of the Global Financial Crisis - found that investors who partook in return chasing behaviour were actually worse off than their ‘buy-and-hold’ counterparts. In fact, the average market timing investor was at least 0.5% a year worse off before transaction costs were factored in, whereas a straightforward ‘buy-and-hold’ approach would have improved an investor’s returns by at least 0.5% every year during that tumultuous period. Importantly, the analysis not only illustrates the cost of market timing but further highlights that it could be one of the more serious mistakes a retail investor makes.
Unfortunately, emotions lead investors astray in other ways too. Another common misstep relates to the selection of investments. For example, when investors dumped money into equity mutual funds between 1999 – 2000, the majority of inflows went towards the internet and technology focused funds which were delivering exceptional returns at that time. In contrast, value funds which delivered more ‘modest’ returns through holding lower price-to-earning ratio shares and higher dividend yielding names experienced large outflows during that period. Unfortunately, investors who chose the ‘hot’ technology funds over the ‘boring’ value funds then suffered heavy losses when the dot com bubble burst, with some never recovering from the subsequent bear market.
The combination of the penalty from market timing and share selection means the gap between the actual returns of investors who engage in speculation and overall market returns is likely even larger than the 0.5% mentioned earlier.
Smart Investing