This article has been written by expert contributor, Duncan Burns, Head of Investments, Asia-Pacific and Head of Equity Index Group, Asia Pacific, Vanguard Australia.
Here’s why market timing can be one of the most serious mistakes investors can make.
2022 was generally a bearer of bad news for most Australian investors. With high inflation and interest rate hikes contributing to financial market volatility, we saw 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.
So why do we continue to engage in such behaviours despite the deluge of data telling us otherwise? Psychologists have identified a human tendency to think we have control over events even when we have none. When applied to investing, this perception can lead us to see imaginary patterns in stock price charts or spot trends when none exist. But as historical data tells us, while the long-term trajectory of the share market is upwards, shorter-term price changes are very close to random.
What lessons can investors take away to avoid these self-sabotaging behaviours and improve their results?
Avoiding the most common pitfalls that chip away at your returns, such as trading too often or selling in a panic after a short-term market decline are a great starting point. Actively choosing to adopt a more disciplined approach towards investing can increase your odds of success in the market too. Diluting risk by holding a small number of widely-diversified funds and avoiding the impulse to sink all available capital into that single fund that skyrocketed overnight can also help. Investors might find it useful to automate aspects of investing such as setting asset allocation targets, periodic re-balancing and regularly contributing to an investment portfolio, to help take the emotion out of investing and resist the temptation to outguess the markets.
While a platitude like “this too shall pass” might not bring much comfort during a major downturn, the reality is that the theory behind buy-and-hold investing is a long-term winner and an easy way to avoid the costs of market timing.
An iteration of this article was first published in The AFR on 26 September 2022.
Duncan Burns is the Head of Investments and Head of Equity Index Group for Asia-Pacific at Vanguard Australia. He is also a member of the Australian executive team. In these roles, Duncan leads Vanguard’s experienced team of investment management and strategy professionals in Australia and Asia. He also oversees the management of Vanguard’s Australian and global equity index portfolios and the firm’s trading operations in the Asia-Pacific region. Learn more about Vanguard here. The above material has been republished with the permission of Vanguard Investments Australia Ltd. An iteration of this article was first published in The AFR on 26 September 2022.
Learn more about Vanguard here.
Prior to making an investment decision, retail investors should seek advice from their financial adviser. This document is intended as general information only.