By CHAS P. SMITH, CPA/PFS
Excerpts Published Thursday, October 9, 2014 by Lakeland Ledger
A recent academic study done by Morningstar reviewed the 2,846 mutual funds tradable in the U.S. from 1996-2008. It showed that less than a quarter of the funds outperformed the overall market after the first five years. Only 195 funds (7% of the total) outperformed the market after 10 years. What are the chances that the average investor is smarter, or knows more information than that of a multi-fund manager overseeing billions in investor assets?
AN EFFICIENT MARKET
The efficient market theory tells us that all information is known and that no one person can predict short-term rises or falls based on fundamental or technical analysis. Furthermore, fund managers find out about public information at the same time as individual investors, which proves that a security’s news has already been built into the price by the time an investor decides to buy or sell the position. This makes it very difficult to outperform the benchmark on information or analysis alone. Luck, as it seems, is the one true determinant of the market timer. What is an investor to do given these dismal odds of beating the index?
A LONG-TERM APPROACH TO INVESTING
Clearly, the short-term approach to investing is luck. Attempting to find the next homerun given public information is lucky at best. An investor can read the financials of start-up companies until their eyes go blind and never find a hidden gem to add to their portfolio hoping it will give them Vegas like returns.
If you don’t have at least 10 years to invest, the market is not the place to stash your assets for potential profit. Instead, more stable assets like zero-coupon bonds or Certificates of Deposits may be a better home given your specific criteria of cash needs.
One way to avoid market timing, while also giving you a bit of peace-of-mind about going “all in” is to dollar-cost-average. This invests a bit of your assets in a frequency mode until all of the assets are invested in the market. For example, investing $10,000 every three weeks until $50,000 is invested, will take four months to complete.
Using this method could help buy in at lower levels, thus allowing more room for profits. The drawback to dollar cost average investing versus loading all of your assets at once is that the market could rise over the entire period, thus creating an opportunity cost lost for not buying “all in” at the low point of the market during that period.
When you try to time the market, you have to be right four times: you have to pick the right security, you have to know when to buy it, you have to know when to sell it, and, finally, you have to know when to repeat that process. Missing any one of those four steps could strike out the opportunity to reach your long-term goals.
In a 2012 DALBAR study covering the 20 years ending 2011, the average stock investor underperformed the S&P 500 by 4.3% per year. The average bond investor underperformed the Bond Index by 5.5% per year during the same period. Conclusion: When the going gets tough, average investors panic. Inappropriate investor behavior (market timing) reduces net returns by 4% to 5% per year!
Sources: The Wall Street Journal and DALBAR
Next time: When You Should Buy Life Insurance
Chas P. Smith, CPA/PFS is president and chief investment officer of CPS Investment Advisors