The stock market is up over 16% so far in 2012. However, based on history, most individual investors have achieved far less. Why? Even conscientious investors have emotions.*
The S&P 500 index has a year-to-date return through Friday, October 5, 2012, of 16.17%. As an individual investor, if you had money in an S&P 500 index fund continuously since January 1, 2012, you should have received something close to a 16% after a slight reduction for any fund expenses and fees. Then why did I say that most investors did not do as well? Because, most investors are not patient enough to leave their funds invested continuously. For example, if you sold out on May 15 as the market showed signs of decline, you only earned 5.8%. If you waited to buy-in until the first trading day in April, you only earned 2.9%. To get the full 16%, you needed to be invested everyday of the year.*
Historical Analysis
Dalbar, Inc. is a respected research company that analyzes trends and compiles data. Over the twenty-year period ending December 31, 2010, Dalbar conducted a study to determine the performance of the individual investor versus the return of the stock market. During this time period, the S&P 500 Index averaged 9.14% a year. However, the average equity fund investor during this same period earned a market return of only 3.83%. This means that most individual investors missed an average of 5.3% return each year during that twenty year period. For a $10,000 investment, this is a difference in earnings of over $40,000!*
The results of the Dalbar research consistently show that the average investor earns well below average market returns.
Emotions are Difficult to Ignore
Why is it difficult for investors to earn the return of the market? It is because they have a difficult time ignoring their emotions. Fear and regret are huge motivators.Everyone knows that the best time to purchase stock is when the price is low and the best time to sell is when it is high. Unfortunately, this is not as easy to do as you might think, especially with our vivid memories of the most recent stock market decline caused by the financial crisis. Many people experienced emotional frustration, and even anger, as they watched their portfolio value decrease in 2008-09. Then, investors rode an emotional rollercoaster as the stock market started its rebound in 2009-12.
Naturally, investors today are more cautious and more conscious of their portfolio value and its fluctuations. This awareness can cause anxiety when focusing on short-term results instead of long-term returns. When we become anxious, selling out of fear or buying out of regret seem like rational actions.
Market Timing is Flawed
Because stock market values fluctuate, an intelligent investor would naturally conclude that if he/she can sell an investment when the price is high, then wait until the price falls and buy it back, then sell when it’s up again and buy when it goes down, and so on, that this routine would earn them an even higher return than the stock market itself. This would be true and, therefore, a great plan for investing. The execution of this strategy is the difficult part. While many market timing models have been created, none have stood the test of time. If a market timing strategy appears to work, it does so only for a very short time. Many investment professionals view this attempt to consistently predict future market price movements as more of a “gamble” than an investment “strategy”.
Better to Stay Invested
Whether an investor is using an intentional market timing strategy or is simply moving in and out of the market based on emotion, the problem with being out of the stock market is the difficulty of knowing when to get back in. Again, the research bears this out. Over the last 20 calendar years, from December 31, 1991 to December 31, 2011, the S&P 500 has a compound total return of over 350%. During this 20 year period, if you were NOT invested in the stock market for its ten top-performing days, your stock portfolio’s investment return would have been less than half. In other words, by missing only 10 days out of the last 20 year period (5,000 potential trading days), the stock portion of your retirement portfolio would have been cut in half.*
Summary
If history has taught us anything about the stock market, it would be that market timing is typically unsuccessful and that emotions can cause investors to focus on the short-term instead of the long term. Based on historical data, it is best to keep funds that are allocated to the stock market invested over the time period. This does not mean you “invest and forget”. An astute investor must do the research, choose the investments, monitor the performance, and make changes to improve the portfolio whenever necessary. If you do not have the time or the interest, the best advice may be to work with a qualified investment advisor who understands your situation and how your money needs to be invested to accomplish your goals.*The source for stock market returns within this article came from Morningstar, Inc.