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Timing Temptation

Buy-and-hold investing is a crock. That's what many investors are saying these days and, after a bruising bear market, it's not hard to understand why. If only they had sold at the top and bought back at the bottom. Problem is, getting the timing right is much easier said than done.

It also turns out that the majority of investors are poor market timers. After all, bubbles get going when everyone becomes infatuated with stocks. If folks stayed away then big bubbles wouldn't get off the ground. Similarly, crashes occur when the crowd flees in panic. This boom and bust pattern is a fundamental feature of the markets and it has been so since time immemorial.

Forget about the generalities. It's easy to determine just how bad the average investor is at timing. Jason Zweig, then of Money Magazine, explored the experience of mutual fund investors after the Internet bubble burst. From 1998 through 2001 the average U.S. mutual fund earned 5.7% annually but the average mutual fund investor earned only 1.0% annually. That's a whopping difference of 4.7 percentage points a year. What happened? Funds posted phenomenal early performance figures and investors loaded up. The bubble burst and they fled. As a result, most fund investors didn't get the good early returns and instead were left with the dross of the later period.

It can be easy to bash funds but stock traders aren't that hot either. A fascinating study by Barber, Lee, Lui and Odean called 'Just How Much Do Individual Investors Lose by Trading?' looked at all of the trades on the Taiwan Stock Exchange starting from 1995 to the end of 1999. Individual traders were a hyperactive bunch in the period and they bought, and sold, all of their stocks nearly 3 times a year on average. Regrettably, all of this trading didn't help and instead reduced gains by 3.8 percentage points a year.

While both studies are a touch dated, there is little evidence that investors have changed their stripes. Even normally level-headed index investors suffer from poor timing. Morningstar.com reports that the Vanguard Total Stock Market Index fund lost 1.59% annually during the 10 years ending April 30, 2009 but index fund investors suffered a 4.04% annual decline. In this case, poor timing reduced returns by 2.45 percentage points annually.

To be fair, investors in some funds get it right and a few investors are quite good timers, overall. But the odds are stacked against the average investor. Most are likely to lose roughly 2 to 5 percentage points annually, over the long run, due to poor timing.

It can be hard to avoid the temptation to time the markets but there are a few things that can help. Importantly, you should minimize regret by design.

If you're like most people, the loss of $100 generates more than two times the emotional impact of a $100 gain. (Losses are of course painful whereas gains are satisfying.) It's a fact of human nature that we feel our losses more keenly than our successes.

To avoid being hit by needless regret, focus on the performance of your overall portfolio and do so relatively infrequently. Avoid constantly looking at the performance of the individual components of your portfolio.

Nassim Taleb used a good example of the dangers faced by frequent performance trackers in his book Fooled by Randomness (ISBN: 0812975219). Taleb considered the case of a smart investor who earns 15% annually with 10% volatility. That is, in any one year the investor has a 68% chance of earning between 5% and 25%, and a 95% chance of earning between -5% and 35%. He has about a 93% chance of posting a gain in any year. If he checks his performance once a year, he is likely to be happy to see a profit and unlikely to be hit with a loss.

But if he looks at his portfolio more frequently then he's much more likely to be in the red. His portfolio has a 77% chance of being up in any particular quarter and a 67% chance of being up in a month. If he checks each day, he only has a 54% chance of seeing a day-to-day gain and he'll encounter bad news 46% of the time. Combine the near even odds of a profit or a loss with the knowledge that losses have twice the emotional impact of gains and you have a recipe for unhappiness. If he checks his performance each day, the losing days are likely to drive him into a fit of depression. Nonetheless, his strategy is quite profitable over the long term and he'd be much happier if he didn't stare at stock quotes all day. Indeed, golfing or gardening might be more efficacious.

The emotional drag due to loss aversion makes frequent trading difficult for most. Day traders are likely to drive themselves into a funk. Instead, the buy-and-hold investor avoids such constant distress.

The second way to minimize loss aversion is to focus on portfolio returns and not on individual stock, or fund, returns. After all, if you hold 20 funds, then some of them are likely to be down at any time and you're likely to pay more attention to the losers than the winners.

Perhaps the easiest way to focus on portfolio returns is to reduce the number of securities you hold. For instance, instead of tracking 20 different funds, it's probably better to simplify and hold only a few core funds. Real purists might opt for a single low-fee balanced fund or exchange-traded fund. That way, they won't be distracted by all of the fluctuating parts and they're forced to only track overall portfolio returns.

In many ways, trying to protect yourself from the urge to trade is difficult. While the buy-and-hold crowd has been much criticized, frequent trading is likely to lead to even worse results for most people. But there is at least one good thing that has come out of the market turmoil of the last decade. You can use the experience as an indicator of your own timing skill.

Just ask yourself, did you load up on high-tech stocks in the late 1990s only to sell out at a loss in the early 2000s? Did you get back in after the run up in the mid-2000s only to sell out at the lows of early 2009? If you did, then you should be worried about your timing skill and take steps to protect yourself from it.

Alternately, perhaps you were selling in the Internet bubble and buying in the bust. Perhaps you sold your stocks in 2006 and early 2007 and then started buying back in early 2009. If so, you're likely part of the small minority with better instincts.

For most of us, the buy-and-hold approach is a defensive strategy. Instead of asking how much we can gain from timing, we focus on how to avoid losing unnecessarily. Buy-and-hold investors prefer to stay clear of the trading game, which they know is stacked against them.

First published in the June 2009 edition of the Canadian MoneySaver.

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