While it’s difficult to be the best investor in the world, we can all actively avoid being a ‘bad investor’ by learning from history and staying the course.
Extended periods of market volatility regularly spark discussions around great investors and the traits that qualify folks to be included in that category.
This is probably because, like most things in life, no one really questions why things are going right; everyone is after an explanation when things aren’t so great.
But rather than focus on what it is to be a great investor or how we could be the next Warren Buffett, perhaps the conversation would be more useful if it was couched in terms of how we could avoid bad investing behaviours that seem to appear when financial markets are turbulent.
Here are a few suggestions from us.
Don’t time the market
It is very common to hear the phrase “time in the market, not timing the market” bandied about but while it sounds logical, analysis backs up both parts of the phrase to explain why it makes sense, rather than take it at face value.
Timing the market is hard, and here’s why. To successfully time the market means an investor has to get not one but the following five factors right, all at the same time:
- Identify a reliable indicator of short-term future market returns.
- Time the exit from an asset class or the market, down to the precise day.
- Time reentry to an asset class or the market, down to the precise day.
- Decide on the size of the allocation and how to fund the trade.
- Execute the trade at a cost (reflecting transaction costs, spreads, and taxes) less than the expected benefit.
To further add to the complexity of the five factors above, getting all five factors right just once is not sufficient to reap the benefits of market timing. An investor would have to do this repeatedly in order to benefit meaningfully from the exercise.
The chart below illustrates this best, showing the return of a $1,000 portfolio in various scenarios, using a traditional balanced portfolio (60% shares, 40% bonds) as the base scenario. It shows that an investor who was right 100% of the time would see a 0.2 percentage point advantage in their annualised returns over 25 years, when compared to a balanced portfolio. Getting things right 75% of the time would see an investor better off than the base scenario at the end of 25 years by $252. And being right half the time meant underperforming the balanced portfolio. Transaction costs were not taken into account in this analysis – meaning the returns would have been even lower had costs been accounted for.
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