Successful investors have learned to see the stock market as a natural home for their savings. They agree with renowned investor Warren Buffett, widely recognized as the most successful investor in history. Buffett has often said that the ideal holding period for stock investors is “forever.” He never sells because of the possibility of a temporary downturn. He sells only when something goes wrong with one of his investments. Here’s why acting on market predictions can often cost you money.
Many successful investors see the stock market as a little like a bank account, but with some crucial differences. Returns in the stock market vary widely from year to year, and are far more volatile than returns on a bank account. That’s a key disadvantage of investing in stocks. But the market’s volatility averages out over long periods. More important, the market’s average return is far higher than the interest rate on a bond or bank account. Dividends and capital gains also come with tax advantages over interest income. To top it off, the stock market provides something of a hedge against inflation.
Most of the time, I have an opinion on where the market is headed. However, I recognize – and you should too – that nobody gets market direction right every time. But you don’t need to predict the future, much less get it right every time. You just need to follow the Successful Investor method, which is what we do for our clients.
How to avoid jinxing your portfolio
The funny thing is that if you try to profit by acting on market predictions, it will often cost you money.
Investors try to improve their returns by taking money out of the stock market when they feel risk is high. They often get this urge after a few weeks or months of bad financial news or unsettling political developments. By then, however, the market may have already dropped far enough to offset any negative developments. Often, these temporary sellers wind up buying their way back into the market when the news has improved, and stock prices have gone above the price where they sold.
All too often, brokers encourage this costly practice. They may advise clients to “take some money off the table,” setting up a false analogy between investing and gambling. That’s in a broker’s interest.
Every sale generates a commission. It also gives the broker the opportunity to sell the client something new and make another commission. The investor may reinvest in a product that’s more profitable for the broker – selling the proceeds of a stock sale to buy an annuity or a universal life insurance policy, say. However, investors at discount brokers also manage to sell low and buy back high, without any broker encouragement.
Dalbar, a Boston financial-research firm, published a pioneering study of U.S. investor returns in 1994, covering the previous decade. In the latest update of its study, it found that the average investor in all U.S. stock funds earned 3.7% annually over the past 30 years. That’s around one third of the 11.1% annual return that the S&P 500 stock index achieved in the three full decades of that period.
Investors underperformed the index mainly by selling or staying out of the market when they saw the outlook as risky, and getting back in when things looked better to them. By then, prices were generally higher. I suspect a similar study of Canadian investors would come to a similar conclusion.
Don’t misunderstand. You need to invest in a way that suits both your goals and your temperament. For you, that may mean holding six months’ worth of income in a money market fund.
Holding cash reserves generally cuts your long-term returns. That’s because six-month interest rates are generally well below the average long-term return in the stock market. But you’ll lose far more if you try to cut risk or improve your returns by moving in and out of the market in response to market predictions (yours or anyone else’s).
To succeed as an investor, you need to get used to the idea that short-term declines come along unpredictably. These declines are common enough that investors continually think about them. But they are far less common than the predictions that the next one is right around the corner.
Courtesy Fundata Canada Inc.© 2015. Patrick McKeoughis a professional investment analyst and portfolio manager. He is the host of TSINetwork.com, where this article first appeared. Investments mentioned are not guaranteed and carry risk of loss.
