The ability to time the market accurately is the holy grail for all investors. Many may claim to have sussed it, but most of them are in the business of selling modelling tools to investors all too willing to believe the idea that some magic formula can make them rich. The simple fact is, there is no such formula.
While there may well be a number of fund managers who consistently outperform the market, year on year, their success is due more to diligent and insightful stock picking based on strong fundamentals than to market timing. And as we know, defensive, low risk stocks outperform higher risk growth stocks over the long term – slowly but surely is a far more successful maxim than fast and loose when it comes to making money in the stock market.
And yet this maxim continues to be ignored by the majority of private investors – the temptation to chase the quick buck remains too strong. Research conducted by Morningstar shows just how damaging giving in to this temptation can be. “There remains a tendency for investors to buy high and sell low. Poor timing is costing them an enormous amount of money”, says Chris Traulsen, director of UK research for the data provider. He cites two simple examples to illustrate the point – the amount of money invested in technology funds just before the sector crashed so spectacularly in 2000, and the inflows of cash into property funds in the last couple of years, when the sector’s strong outperformance had all but played out. Indeed, one sure fire sign that any sector is becoming overvalued is a raft of new fund launches, accompanied by aggressive advertising campaigns, by investment houses that see an opportunity to increase assets under management. Attracting as much money as possible is the raison d’etre for most fund managers, and if the sector in which one of their newly launched funds invests should collapse, so be it – they can always point to all the other newly launched funds of their competitors that should have performed just as badly. It’s a win win situation for the managers, but not for investors.
And the impact of chasing strong performance through bandwagon funds can be dramatic. Morningstar has introduced what it calls ‘Investor Returns’ that sit alongside its traditional ‘Total Returns’ figures in the US. It plans to roll out the same methodology in the UK. We are all familiar with total returns – the amount a fund has risen in value between two specific dates. But investor returns take into account inflows and outflows of cash – they effectively place more emphasis on performance produced when assets under management are high, and less on performance when assets are low. And the difference between the two types of return can be significant. In one example, a volatile US fund that had an impressive annualised total return of 15 per cent over the ten year period up to the end of 2006, actually had an investor return of minus 1.5 per cent. The reason is very simple – the year before the fund crashed by 60 per cent in 2000, assets went up by a massive 505 per cent. In contrast, a much less volatile fund, also with an annualised total return of 15 per cent but with inflows and outflows of cash never exceeding 12 per cent in any one year, had an investor return of 14.8 per cent. These are extreme examples chosen to make a point, but there is a marked difference between the two types of return over a much larger sample. The average annualised total return over the same time period for equity sector funds in the US was 10.4 per cent, against an investor return of just 7.6 per cent. But the average balanced fund had a total return of 9.1 per cent against an investor return of 8.9 per cent. For low standard deviation funds the figures were 8.7 per cent versus 8.5 per cent. For high standard deviation funds, they were 8.3 per cent versus 5.1 per cent.
The message is very clear – actively chasing outperformance through volatile funds is detrimental to you financial health. As Mr Traulsen says: “You are much better off sticking with your long term strategy”.
