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, Buckingham (75 clicks)
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"Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves." Peter Lynch, Worth (September 1995)

A good friend, Sherman Doll, who, like me, is a financial advisor, related the following story. He has been a two-line sport kite flier for several years. While not a pro, he has learned a few tricks by observing the flying behavior of these kites. He told me that one of the most difficult skills for beginners to master is what to do when their kite starts to plunge earthward. The natural, panicky impulse is to yank backward on the lines. However, this action only accelerates the kite’s death spiral. The simple kite-saving technique is to calmly step forward and thrust your arms out. This causes the kite’s downward acceleration to stop, allowing you to regain control of the kite and end its plunge. What does this have to do with investing?

On January 21, 2008 the global equity markets all collapsed. In just that one day, stock markets fell from about 5 percent to as much as 10 percent. For some markets it was the worst day since the Great Depression. And the Australian market had its worst day ever. The U.S. market, which was closed for Martin Luther King Day, saw the futures market trading down over 500 points ahead of the opening on the 22nd. This type of market move generally leads to panicked selling. And the media fuels the frenzy.

As I have learned to expect, I received two phone calls from the media to discuss what investors should be doing in light of the bear market spreading around the globe. What I find amusing is that I always give them the same answer—investors should do nothing except adhere to their well-thought-out investment plan, assuming they are knowledgeable enough to have one.

While it is tempting to believe that there are those that can predict bear markets and, therefore, sell before they arrive, there is no evidence of the persistent ability to do so. On the other hand, there is a large body of evidence suggesting that trying to time markets is highly likely to lead to poor results. For example, one study on the performance of 100 pension plans that engaged in tactical asset allocation (a fancy term for market timing, allowing the purveyors of such strategies to charge high fees) found that not one single plan benefited from their efforts.[1] That is an amazing result as randomly we should have expected at least some to benefit.

Another study also found some amazing results. For the twelve years ending in 1997, while the S&P 500 Index on a total return basis rose 734 percent, the average equity fund returned just 589 percent, but the average return for 186 TAA funds was a mere 384 percent, about half the return of the S & P 500 Index.[2]

A third example of the futility of trying to time the market is the finding from a Morningstar study. They found that investors in mutual funds on average significantly underperform the very funds in which they invest. In other words, the dollar-weighted returns of investors are below the time-weighted returns of the funds in which they invest. The reason for this seemingly strange outcome is that investors tend to buy after periods of strong performance and sell after periods of weak performance. Buying high when greed takes over and selling low when panic sets in is not exactly a recipe for financial success. Unfortunately, it is the way most investors act.[3]

Summary

Returning to my friend’s story about flying kites. Just as when a kite starts to plunge earthward the natural, panicky reaction is to yank backward on the lines, the natural, panicky reaction to a dive in your portfolio’s value is to pull back (sell). In both cases, pulling back is the wrong strategy. The right strategy is the less-intuitive one of remaining calm and stepping forward (actually buying stocks to rebalance your portfolio to the desired asset allocation).

Warren Buffett is probably the most highly regarded investor of our era. Listen carefully to his statements regarding efforts to time the market.

  • “Inactivity strikes us as intelligent behavior.”[4]
  • “The only value of stock forecasters is to make fortune-tellers look good.”[5]
  • “We continue to make more money when snoring than when active.”[6]
  • “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”[7]

Buffett also observed:

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’ If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.[8]

Perhaps Buffett’s views on market-timing efforts are best summed up by the following from the 2004 Annual Shareholder Letter of Berkshire Hathaway:

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

The above observation is perhaps why Buffett has stated that investing is simple, but not easy.[9] The simple part is that the winning strategy is to act like the lowly postage stamp that adheres to its letter until it reaches its destination. Investors should stick to their asset allocation until they reach their financial goals. The reason it is hard is that it is difficult for most individuals to control their emotions—emotions of greed and envy in bull markets and fear and panic in bear markets. In fact, bear markets are the mechanism that serves to transfer assets from those with weak stomachs and without investment plans to those with well-thought-out plans—with the anticipation of bear markets built right into the plans— and the discipline to adhere to those plans.

The bottom line: If you don’t have a plan, develop one. If you do have one, stick to it.

Endnotes:

1. Charles Ellis, Investment Policy (Irwin Professional Pub 2nd edition 1992).

2. David Dreman, Contrarian Investment Strategies, p. 57 (Simon & Schuster, 1998).

3. Morningstar FundInvestor (July 2005).

4. 1996 Annual Report of Berkshire Hathaway.

5. 1992 Annual Report of Berkshire Hathaway.

6. 1996 Annual Report of Berkshire Hathaway.

7. 1991 Annual Report of Berkshire Hathaway.

8. 2006 Annual Report of Berkshire Hathaway.

9. Financial Analysts Journal, November/December 2005, p. 51.

Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.

Source: Market Timing: Don’t Let Emotions Take Control