Investors should not forget their well-laid plans, even when markets tumble
From Standard & Poor's Equity ResearchOn the popular cable television show Top Chef, contestants often remind each other when facing the judges to "Stand behind your dish" and "Stand firm."
The advice to stand firm and believe in your own decisions also applies to investing.
Unfortunately, many investors appear to be too easily swayed by market externals, and fail to stand behind their plans.
In fact, "the evidence suggests that most [investors' portfolios] significantly underperform both the stock market and the very mutual funds in which they invest," according to Larry Swedroe, a financial planner and author of Wise Investing Made Simple.
Swedroe cites a recent study by Morningstar, a fund research company, which found that in 17 different fund categories, the returns earned by individuals were below the returns of the very funds in which they had invested. This can be partly explained by the fact that investors often trade on emotion. For example, among large-cap growth funds, the 10-year annualized, dollar-weighted return was 3.4% less than the time-weighted return (the return reported by the fund). For mid-cap growth and small-cap growth funds, the underperformance was 2.5% and 3%, respectively. Investors in sector funds fared worse, with tech investors producing particularly disastrous results, underperforming by 14% per year.
And fund investors are not the only ones experiencing this conundrum.
Another study, this one by Brett Trueman, a professor of accounting at UCLA's Anderson School of Management, found individual stock investors make decisions that are detrimental to their portfolios. Specifically, the UCLA study looked at 293,630 earnings releases over the past 35 years, and divided them into tranches, according to returns 12 months after the earnings release.
"The top 1% of stocks with earnings released when the market was closed ran up the five days prior to the release and fell 3% in the five days following," wrote BusinessWeek in a brief on the UCLA study. "Behind the move: small investors rushing to buy and pushing prices up. When the announcement came, they stopped buying and got clobbered as the stock fell. Then the stock resumed its upward march."
Trueman told BusinessWeek that long-term investors "shouldn't worry about a break in momentum. Don't necessarily interpret it as bad news," he says. "After a few weeks they [stocks] start rising again."
Why do investors behave in ways that hurt their portfolios?
Swedroe thinks he can speculate on an answer to that question.
"Investors allow their emotions to impact their investment decisions," he says. "In bull markets, greed and envy take over and risk is overlooked. In bear markets, fear and panic take over, and even well-thought-out plans can end up in the trash heap of emotions."
Recent market activity suggests bear market panic may be happening in today's markets. In the first four months of the year, the S&P 500 fell 6%, as investors looked to exit stocks.
S&P Chief Economist Sam Stovall thinks investors may be exiting at exactly the wrong time. He notes that consumer confidence is quite low these days (see cover table). Ironically, low consumer confidence has, historically, been a good contrarian indicator of bullish times ahead for the stock market. Of course, investors should note past history is no guarantee of future results.
"In general, whenever the consumer confidence index has fallen below 76 (one standard deviation below the average of 97 since 1977), bad news about our economy's state of affairs is so pervasive that everyone is talking about it, which may signal that the worst is over," says Stovall.
"Historically, the S&P 500 has gained more than 20% per annum after a period of extreme investor pessimism," agrees Arieh Coll, portfolio manager for the Eaton Vance Tax-Managed Multi-Cap Growth fund. "What's more, pessimistic consumers lead to S&P 500 gains of more than 26.9% six months later. For this and other reasons, we think the bear market is dead."
Another supporter of this position is the legendary investor, Sir John Templeton, who once famously said, "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria."
S&P Equity Strategy advises a 55% weighting to U.S. stocks in its aggressive portfolio, a 45% weighting in its moderate portfolio, and a 30% weighting in its conservative portfolio.
So how can investors find a way to stand by their investment plans even in tough times?
First and foremost, they've got to have a plan. Standard & Poor's recommended ETF Asset Allocation Portfolios could be a first step for investors trying to determine the right asset allocation.
Of course, standing firm does not mean buying a security and then walking away forever. Every investor should rebalance his or her portfolio at least once annually, to maintain the desired asset allocation. While everyone knows, in theory, that "buy low, sell high" is the key to investment success, it can be hard to put this theory into practice. If you are doing your annual portfolio rebalancing, and one investment has jumped up considerably while another has lagged, you should sell the winner and buy the loser. It seems few individual investors can bring themselves to do so.
However, it seems that's exactly what the pros are doing. According to the Merrill Lynch April global fund manager survey of 202 fund managers, fund managers are more bullish on U.S. stocks than a month earlier. Not only do they express that bullish sentiment to survey takers, they are acting on it. The average cash position at mutual funds fell to 4.2% in April, down from 4.9% in March. Professional investors are not sitting with cash on the sidelines. They are putting that cash to work. Depending on your age and risk tolerance level, perhaps you should, too.