Investors typically resort to panic selling during bad times. The Dalbar report explains why staying invested is critical to successful investing
Investors are constantly reminded that staying invested is the key to successful investment. But when the values of their portfolios plummet due to poor-performing equity markets, fear invariably takes over and it becomes increasingly difficult to adhere to that advice. In fact, most investors go into a selling frenzy when markets decline.
Investors who are experiencing that sinking feeling can take heart from the latest findings from US-based research firm Dalbar. The latter has been measuring the effects of investor decisions to buy, sell and switch into and out of funds since 1984. In its 2008 report, it examines real investor returns for funds of various asset classes for the 20 years ended Dec 31 last year.
Staying invested does pay off
One key finding is that unit trust investors who hold their investments typically earn higher returns over time than those who time the market. Dalbar explains that retention is ‘critical’ to investment success because one cannot benefit from the market if one is not in the market. This is because though it is beneficial to avoid market downturns, very few investors actually do so consistently and successfully.
The key, says the report, is to remain invested to reap the benefits of any market gains.
‘During the last 20 years, equity investors would have realised monthly gains 65 per cent of the time. In other words, their chances of making money would have been nearly seven in 10,’ says the report.
Guessing it wrong
Using its Guess Right Ratio, Dalbar highlights the problem that investors face. It appears that most investors are able to make the right decision in a rising market but they are unable to guess the direction of the market correctly after a bear market.
These investors typically guess wrongly that the market would not recover - an assumption based on fear. As a result, they stayed on the sidelines as the market recovered. But the ‘really smart decision’, says Dalbar, is to invest when the market is down.
Its Guess Right Ratio measures how often the average equity investor correctly ‘guesses’ the direction of the market. Net mutual fund inflows and outflows are used to determine if investors made short-term gains by correctly anticipating the direction of the market. The average investor guesses right when there is either net inflow each month followed by a market rise or net outflow followed by a downturn.
An analysis of the 20-year period ended last Dec 31 shows that equity investors were more often right than wrong. However, the periods of incorrect guessing had an impact on their portfolios. Perhaps not surprisingly, the Guess Right Ratio was highest - at least 67 per cent or eight out of 12 months - during years when markets posted strong returns and, with few exceptions, lowest during market declines. The overall Guess Right Ratio for the 20-year period is 61 per cent.
This is why Ms Penny Lim, director at financial advisory firm FPA Financial, does not recommend that clients try to time the market by selling out and waiting to get back in later at a lower price.
‘It will be risky to do so now, as you could end up being out of the market when it rebounds. Judging from the level of pessimism, the level of cash holdings, the upswing could come fast and steep too. You don’t want to take the risk that you could be out of the market when it recovers,’ she said.
Buy and holding period
A contributing factor to the poor investor performance is the ‘less-than-ideal’ holding period, says the Dalbar report.
Its research shows that equity shareholders usually sell their holdings in less than four years. This implies that investors do not have the patience or emotional discipline to weather market dips. In fact, the current trend indicates that the average holding period for funds has deteriorated, no thanks to the US sub-prime mortgage crisis and subsequent economic downturn.
It is no wonder Dalbar finds that over the 20 years ended last December, the average equity fund investor would have earned just 4.48 per cent a year, compared with the S&P 500’s annualised return of 11.8 per cent. This translates into an underperformance of more than 7 per cent a year.
Proper asset allocation
A tip on containing investor fear and avoiding market timing is to focus on risk control.
‘Have an asset allocation that gives you a comfortable downside. If you can stomach 10 per cent annual loss, then find an allocation that gives you that,’ said Mr Chris Firth, chief executive of wealth management firm dollarDex.
This is because you are less likely to panic when the inevitable bad period comes along.
Building a suitable asset allocation requires an understanding of your risk tolerance, time horizon and your required rate of return, said Mr Ben Fok, chief executive of Grandtag Financial Consultancy.
Still, it doesn’t mean that investors can take a backseat and relax once a portfolio is set up. It should be reviewed at least quarterly.
Balancing your portfolio
Another piece of advice given by investment experts is to buy low, sell high, something which most investors would agree is easier said than done.
But if you are constantly rebalancing your portfolio, you are in effect already buying low and selling high, said Mr Fok.
Rebalancing is an effective means of bringing your portfolio back to your original asset allocation mix of stocks, bonds and cash. It is necessary because over time some of your investments might become ‘out of alignment’ with your investment goals.
For example, your initial asset allocation might have been 60 per cent equity, 30 per cent bonds and 10 per cent cash.
Due to the bullish stock market, your asset allocation changed to 80 per cent equity, 15 per cent bonds and 5 per cent cash. Accordingly, you should rebalance the portfolio to get back to the initial asset allocation.
You do this by selling 20 per cent equity and buying an additional 15 per cent bonds and 5 per cent cash. Rebalancing requires you to sell assets that are performing well and buy assets that are currently out of favour.
By doing so, you’ll ensure that your portfolio does not overemphasise one or more asset categories, and you would return your portfolio to a comfortable level of risk, added Mr Fok.
Don’t time the market
‘Judging from the level of pessimism, the level of cash holdings, the upswing could come fast and steep too. You don’t want to take the risk that you could be out of the market when it recovers.’
Ms Penny Lim, director at financial advisory firm FPA Financial, advising clients not to sell out in panic and wait to get back in later
Think long-term and ignore the noise
Retail investor and businessman Felix Lee, 48, believes in staying invested for the long haul, even during times of poor market sentiment. He admits to feeling anxious about the present volatile state of equity markets, but is not afraid.
‘If you have diversified your investments nicely, there is a sense of anxiety towards your mid-term investments, but the emotion is not one of fear,’ said Mr Lee.
His investment portfolio includes Prudential’s Prulink Singapore Managed Fund and the First State Bridge Fund which he has held for 12 and five years, respectively.
He attributes his ability to ignore the noise in the market to proper asset allocation and an understanding of his risk profile.
‘My investments are apportioned into current, three-year and five-year horizons. For my mid- to long-term investments, I don’t bother with the ups and downs because I’m not cashing out now,’ said Mr Lee, who is willing to stomach investment losses of up to 20 per cent in a year.
‘There is no point in timing the market because I’m investing for the long haul.’
After all, economies do move in cycles, he added.
Fortunately for him, his portfolio is still above water, with returns of 4 to 5 per cent so far this year, down from returns of 8 to 12 per cent last year.
Still, some investments have a shelf life and Mr Lee emphasised that this is the case for thematic funds as their popularity was fuelled by trends.
For instance, he invested $150,000 in two BRIC funds for a year before deciding to liquidate them about five months ago when the funds appeared to be losing strength.
BRIC funds invest in the economies of Brazil, Russia, India and China and were hotly pursued by investors in the past few years.
Source : Sunday Times - 31 Aug 2008
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