Stock owners have been through an emotional roller coaster over the past 10 weeks. In December 2018, prices on stock markets worldwide plunged by more than 12% at their lowest point, only to rise again by 14% since then. These fluctuations were a reminder that no attractive return can be earned without risk. In that sense, the past few weeks are a prime example of the constant ups and downs that are so typical of stock markets.
What's interesting is how investors reacted to the market slump in December. According to the latest figures from fund analysis house Morningstar, investors withdrew $143 billion from actively managed funds in December alone (the figures relate to the US). Never before had the exodus been so enormous. For comparison: in the remaining 11 months of 2018, the outflows amounted to „merely“ $158 billion. Some of the money did stay invested in December and was shifted into low-cost index funds – $60 billion, to be exact – but this general trend toward forecast-free forms of investment is not what we're concerned with here. We find it remarkable that investors withdrew from the market in droves, just before January delivered the best returns in a long time.
This failed attempt to time a favorable exit is so typical of investors that a term of its own has emerged for it: the "behavior gap." What it means is that investors systematically buy after price rises and, disappointed, sell after price losses. So they buy in at high prices and sell out at low ones, which leads to a return gap compared to staying invested throughout. Morningstar measured this gap using real fund and investor returns and arrived at 1.4% per year that investors forgo through harmful timing behavior.
As unwise as such behavior may seem at first glance, it is just as hard to break in practice. Because the urge to judge investments by their historical return is all too natural: people buy what has performed well in the past. But if an investment made a loss, it gets sold off, so as not to „throw good money after bad.“ Yet good historical returns cannot be extrapolated into the future. If anything, exactly the opposite effect can be observed: after good years on the stock market, the market develops somewhat more weakly – but still positively – while after bad phases, it rises at an above-average rate.
So private investors intuitively make exactly the wrong trading decision, which leads to the return gap described above. Let us add a note on these measurements: of course, if you set costs aside, the entirety of all investors must mathematically and necessarily earn the return of the overall market. So if private investors show a return gap on their investments in active funds, there must be a return surplus somewhere else on someone's portfolio statement. But more on that in a moment.
What can you do about the return gap?
The return gap can be overcome. For one thing, simply becoming aware of it already helps. Before your next sell order, you should calmly ask yourself: Can I really not bear any further losses? Won't I also be disappointed if I sell now and the market rises again afterward? Does it make sense to decide against equities now, when I considered them an attractive investment only recently – back when they were more expensive?
It's even better not to look in the first place. Anyone who doesn't register market fluctuations at all can't react to them incorrectly either. A savings plan is a good tool here, because it lets you automate your saving. Alongside the gain in convenience, there is the pleasant side effect that you also systematically buy at low prices.
Investors with steady nerves even manage to turn the return gap into a surplus. Anticyclically shifting out of asset classes that performed above average in the past and into asset classes that performed poorly takes advantage of the procyclical behavior of the other investors, and historically has generated an excess return of around 0.4% per year. quirion's rebalancing mechanism takes advantage of precisely this effect.
To make this clear once and for all: it is not possible to systematically predict the upward and downward movements of the markets. This „market timing“ has rightly been described as an investment sin, as fund manager Cliff Asness once wrote. This is all the more true when it's so easy to get the sign wrong. But his recommendation to "sin a little" is one we are happy to follow within our systematic rebalancing approach – without confusing buying with selling.
